Wednesday, January 14, 2009

Ilargi: Right, inflation again. Let's make one thing clear: To go from deflation to inflation, you need an economic recovery. But where is that recovery going to come from? We can all agree that in order for a recovery of any kind to happen, we need to instill confidence in the economy. However, all we see is credit being handed out by the trillions. We don't see confidence.

And besides, pray tell, what do we mean when we say recovery? Most politicians and pundits have visions of housing markets returning to former growth levels -perhaps just a little less growth- as well as to former price levels. And for the Dow Jones to soar back to 14.000 points or more, and Detroit to sell 17 million cars per year. Apart from the question if such recovery is desirable -it wouldn't exactly show we have learned much-, there's also another little query: is it at all possible?

No, it isn't, not for the next ten years at least. A large part of the reason why lies in the fact that governments all over the world mess up their approaches and reactions so badly, it would be sad if it weren't so funny. They don't want a new and changed world, they want the old one back, and with more of the same old. As long as you believe in the fact that that is possible, how could you possibly get things right? The main issue is not that banks don't lend anymore, the main issue is WHY they don’t do that.

And there we get back to confidence. Banks don’t lend, and don’t trust each other, because they know they all have huge losses hiding in their vaults and their immediate futures. It has taken us two weeks into the new year to arrive at a point we should have addressed a long time ago: banks will need an enormous amount of additional credit just to stay afloat. HSBC used to be known as one of the best capitalized banks in the world; today, it needs to raise $30 billion. What does that mean for its more fragile peers?

Now, US and UK leaders are finally talking about this, but it has been clear forever. The writedowns that will occur in the next few weeks have been waving big red flags and honking earpiercing horns at us for months. Why it takes Bernanke so long to even mention it can only be answered by saying he has deliberately kept information secret that he's been sitting on all the time.

And there's a twist these days. Both the US and the UK are talking about setting up bad banks to buy up banks’ toxic casino bathroom tissue. Way too late. Ne'er a penny should have been injected in them without the demand to reveal what rots in their darkest coffers. Taxpayers’ money has so far been doled out to institutions that may have $10 trillion or more in losses each. That’s the definition of a black hole.Here's how Britain wants to approach the problem:

One [way] would be to buy toxic assets from lenders and transfer them into a bad bank. The problem with this option is that if banks have not written down the value of their assets aggressively enough, they may have to suddenly crystalise new losses when assets are sold to the Government. The alternative is for problematic investments to be left on banks' own balance sheets but to be ring-fenced and given a Government guarantee. This plan would be harder to implement but would avoid the need for another round of write-downs by some lenders. Northern Rock could be used to house the bad bank, analysts believe.

"Suddenly crystalise new losses" is of course nonsense, there's nothing new about the losses, they were already there when the billions were pumped into the banks. That is the very essence of why these politicians need to be prevented from doing more of what they've already done. "be ring-fenced and given a Government guarantee" is important if we wish to understand how the toxic debt problem will be handled by our chosen few. They want to keep on hiding the stuff. If a government buys the "Papier WC" outright, it will have to assign a price to it. And that it doesn't want to do, because it would get as ugly as my aunt Sally.

So the Brits now plan to ring-fence it, to basically say that whatever is in those vaults, and without the need to even look at it, the British taxpayer guarantees all future losses. That idea is so monstrously perverted, there's no doubt Ben Bernanke and Tim Geithner will like it too. But there will come a point where one or the other of the counter parties in that labyrinth will simply want to cash in, if only because its survival depends on it. It's a strategy that goes nowhere, and has nothing at all to do with a road to recovery.

Here’s more of the Johns. There's a series of clips at YouTube of a show called Silly Money where this comes from. Worth the watch.

The risk of losses on European government bonds is mounting as the economic slowdown threatens credit ratings in Spain, Portugal, Ireland and Greece. Credit-default swaps tied to the debt of Spain rose 59 basis points since September to 109 basis points, while those for Portugal increased 72 basis points to 112 basis points and Greece jumped 154 basis points to 232 basis points, according to CMA Datavision in London. Contracts linked to the debt of lower-rated Mexico and Vietnam fell in the same period.

The region’s economy is faltering after the European Central Bank failed to lower interest rates as fast as the U.S. and U.K. The shadow ECB council, a group of economists that monitors the central bank, said yesterday it expects Europe’s economy to shrink 1.8 percent this year. That compares with a contraction of 1 percent in the U.S., according to a survey by Bloomberg News. “The peripheral countries are coming under pressure,” said Ian Stannard, a currency strategist at BNP Paribas SA in London. “Given the huge supply of bonds that’s due, this is going to make things more tricky. It’s going to leave the euro extremely vulnerable.”

The 16-nation common currency closed yesterday at $1.3182 in New York, down from last year’s high of $1.6038 on July 15. The ECB meets tomorrow to decide borrowing costs and will likely cut its target rate to 2 percent from 2.5 percent, according to the median estimate of 59 economists surveyed by Bloomberg. Merrill Lynch & Co.’s European Union Government Bond Index is down 0.58 percent this year after rising 9.83 percent last year. The firm’s index of German bonds gained 12.2 percent, while one tracking Spanish debt increased 8.78 percent. The index tracking U.S. Treasuries surged 14 percent.

Portugal yesterday became the third euro nation in a week to be threatened with a debt downgrade when Standard & Poor’s said the country’s long-term rating may be lowered from AA-. “In our opinion, Portugal faces increasingly difficult challenges as it tries to boost competitiveness and persistently low growth against the backdrop of a heavy debt burden and very high imbalances,” S&P said in a statement. Government attempts at reform “have proven insufficient,” it said.

Portugal’s government forecast that it will record a budget deficit of 3 percent of gross domestic product in 2009, the edge of the European Union’s limit under the Stability and Growth Pact. The economy will contract this year for the first time since 2003 as its main export markets weaken and Portuguese consumers rein in spending, the central bank forecast Jan. 6. Two days earlier S&P said Spain faced “significant challenges” and may have its top AAA classification lowered. Greece was put on watch for a possible cut as sliding support for the government hampers the country’s ability to ride out the economic crisis, S&P said Jan. 9. The same day, it lowered the outlook for Ireland’s debt to “negative” from “stable.”

Credit-default swaps on Portugal rose 5.5 basis points to 112 basis points after S&P’s move, up from about 40 basis points, or 0.4 percentage point, in September. A basis point on a credit- default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year. Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a country or company fail to adhere to its debt agreements. An increase signals deterioration in the perception of credit quality; a decrease, the opposite.

There is an “increasing disparity and deterioration in the quality of European sovereigns,” Emma Lawson, a currency strategist in London at Merrill Lynch, wrote in a report yesterday. Five-year credit swaps on Mexico have fallen 81 basis points to 309 basis points since Oct. 13, CMA data show. Contracts on Vietnam have dropped 43 basis points to 415 basis points. Ireland has the highest credit swaps for a AAA rated nation in the European Union, with contracts trading at 192 basis points, CMA data show. Italy is the highest of the AA’s, trading at 163 basis points, and Estonia, rated A by S&P, is at 496 basis points.

Yields on the bonds of smaller European economies, such as Spain, Italy and Greece, have risen to the highest relative to German bunds since before the ECB was established a decade ago. Spanish 10-year notes yield 99 basis points more than bunds, up from 17 basis points one year ago. For Italian notes, the gap almost quadrupled to 141 basis points from 36 basis points. “Much of the rationale behind these moves has been focused on the risk of a breakup in the euro or a specific country being ejected from the union,” Charles Diebel, the head of European interest-rate strategy at Nomura International Plc, wrote in a note to clients. “This makes little sense and is not a valid risk scenario at this point in time.”

Budget deficits are rising across the 16-region euro region as Europe faces a recession that may be the worst since World War II. The economy will shrink 1.8 percent in 2009, twice as much as in 1993 and four times what the ECB forecast last month, Royal Bank of Scotland Group Plc economist Jacques Cailloux in London wrote in a report to clients yesterday. The slump is putting the ECB under pressure to cut its key interest rate again this week even after it reduced it by 1.75 percentage point since early October. The Federal Reserve has already cut its target rate for overnight loans between banks to as low as zero.

“The ECB is behind the curve in its rates policies and the sooner this can be corrected, the better,” Erik Nielsen, chief European economist at Goldman Sachs Group Inc. in London and part of the shadow ECB, said in an e-mailed report yesterday. Spanish Finance Minister Pedro Solbes said Jan. 13 that the country’s budget deficit will “substantially” exceed the European Union’s limit of 3 percent of GDP this year. Europe’s downturn may take the biggest toll on countries already saddled by debt. Italy’s burden rose to 109 percent of gross domestic product in October, the highest in the euro region, and the International Monetary Fund in Washington estimates that will limit Prime Minister Silvio Berlusconi’s ability to revive the economy.

Ireland will see more demolition than construction of houses over the next decade, as the economy struggles to recover from the collapse of the housing market and the emergence of “zombie” banks, UCD economist Morgan Kelly told the conference.In a presentation that drew several collective intakes of breath, Mr Kelly predicted that house prices would fall by 80 per cent from peak to trough in real terms.“Construction, but not demolition, of residential and commercial property will fall to zero for the foreseeable future,” he said.

Low levels of education among those employed in construction – where worker numbers peaked at about 280,000 – meant retraining would not be straightforward. Recovery will be slow: “It has taken us 10 years to get into this situation – it will in all likelihood take us 10 years to get out of it.” Mr Kelly said he had been hailed as being extremely prescient as a result of his warnings in relation to the property bubble, when in fact he and a handful of other “amateurs” were merely stating what was obvious. Sparing no blushes, he said professional economists in the Central Bank and the Economic and Social Research Institute “need to look very closely at their analyses of the Irish economy and figure out what went wrong”.

Mr Kelly said Ireland’s “reputational capital” had been damaged by “chancers” such as ex-Anglo Irish Bank chairman Seán FitzPatrick, who had been abetted by “buffoons” such as former financial regulator Patrick Neary, Minister for Finance Brian Lenihan and the Taoiseach. In discussing the €110 billion given in loans to developers, Mr Kelly said a typical regional housing collapse in the US saw banks sustain a 20 per cent loss on these loans, but the narrowness of the Irish market increased the risk of “substantially larger losses” for Irish banks.

“The guarantees of Anglo and [Irish] Nationwide liabilities have a strong chance of being called in over the next 21 months,” he said. Extending the Government guarantee to these two financial institutions was “extraordinarily unwise” and could produce losses that the State cannot afford to repay. The global financial crisis may have been positive for the Irish economy as it “stopped us dragging ourselves even deeper into our hole,” he said. “If it had taken another year or two, we would have ended up in an Icelandic-shaped hole, which is not to say that we won’t end up in one.”

Mr Kelly said the Government should abolish stamp duty on property, compile proper price and quantity statistics and restore competitiveness through a public sector pay cut of 10 per cent. A paper by TCD economist Patrick Honohan on the banking crisis argued that capital injections in the banks were a prerequisite for recovery. The financial regulator needed to decide now which banks had systemic importance to the economy – in other words, are “too big to fail”, and which are “zombie” banks. “The goal is to avoid the continued operation of an undercapitalised, error-prone bank with a flawed business model and administrative practices, a problematic customer base and a compromised management facing distorted incentives,” the paper stated.

Freight rates for containers shipped from Asia to Europe have fallen to zero for the first time since records began, underscoring the dramatic collapse in trade since the world economy buckled in October. "They have already hit zero," said Charles de Trenck, a broker at Transport Trackers in Hong Kong. "We have seen trade activity fall off a cliff. Asia-Europe is an unmit?igated disaster." Shipping journal Lloyd's List said brokers in Singapore are now waiving fees for containers travelling from South China, charging only for the minimal "bunker" costs. Container fees from North Asia have dropped $200, taking them below operating cost. Industry sources said they have never seen rates fall so low. "This is a whole new ball game," said one trader.

The Baltic Dry Index (BDI) which measures freight rates for bulk commodities such as iron ore and grains crashed several months ago, falling 96pc. The BDI – though a useful early-warning index – is highly volatile and exaggerates apparent ups and downs in trade. However, the latest phase of the shipping crisis is different. It has spread to core trade of finished industrial goods, the lifeblood of the world economy. Trade data from Asia's export tigers has been disastrous over recent weeks, reflecting the collapse in US, UK and European markets. Korea's exports fell 30pc in January compared to a year earlier. Exports have slumped 42pc in Taiwan and 27pc in Japan, according to the most recent monthly data. Even China has now started to see an outright contraction in shipments, led by steel, electronics and textiles.

A report by ING yesterday said shipping activity at US ports has suddenly dived. Outbound traffic from Long Beach and Los Angeles, America's two top ports, has fallen by 18pc year-on-year, a far more serious decline than anything seen in recent recessions. "This is no regular cycle slowdown, but a complete collapse in foreign demand," said Lindsay Coburn, ING's trade consultant. Idle ships are now stretched in rows outside Singapore's harbour, creating an eerie silhouette like a vast naval fleet at anchor. Shipping experts note the number of vessels moving around seem unusually high in the water, indicating low cargoes.

It became difficult for the shippers to obtain routine letters of credit at the height of financial crisis over the autumn, causing goods to pile up at ports even though there was a willing buyer at the other end. Analysts say this problem has been resolved, but the shipping industry has since been swamped by the global trade contraction. The World Bank caused shockwaves with a warning last month that global trade may decline this year for the first time since the Second World War. This appears increasingly certain with each new batch of data.

Mr de Trenck predicts Asian trade to the US will fall 7pc this year. To Europe he estimates a drop of 9pc – possibly 12pc. Trade flows grow 8pc in an average year. He said it was "illogical" for shippers to offer zero rates, but they do whatever they can to survive in a highly cyclical market. Offering slots for free is akin to an airline giving away spare seats for nothing in the hope of making something from meals and fees.

Retail sales fell in December for a sixth consecutive month, the government reported on Wednesday, as Americans holstered their credit cards and cut back on spending, even as stores offered discounts of 80 percent to entice shoppers. Sales at department stores, restaurants, gas stations and a host of other retail businesses fell 2.7 percent last month — nearly double what economists had been expecting — and were 9.8 percent lower than sales last December, the Commerce Department reported. Wall Street fell sharply on the report with the Dow Jones industrial average dropping more than 220 points after about an hour of trading. The broader Standard & Poor’s 500 index was down 3 percent.

The new retail numbers offered an epitaph for what economists and retailers called the worst holiday shopping season in decades: Electronics sales were down 1 percent in December from a month earlier; food and drinks fell by 1.4 percent, and sales at clothing stores were 2.5 percent lower, the Commerce Department said. “People hunkered down pretty dramatically,” said John Silvia, chief economist at Wachovia. “Yes, everybody celebrated the holidays, but there was far less spending than in prior years.” Consumer spending, which accounts for more than two-thirds of the economy, has virtually dried up since mid-September as the problems on Wall Street began to spread. With the uncertainty of jobs weighing on consumers, economists do not expect a turnaround anytime soon.

The recession, which began in December 2007 and is already the longest on record, is expected to last into the second half of 2009.In help spur the economy and restore confidence, President-elect Barack Obama has promised to push a stimulus package of about $800 billion, which he is pressing Congress to pass in the weeks ahead. According to the Commerce Department, retail sales for 2008 fell 0.1 percent from 2007, with most of the losses coming from a 7.7 percent drop during the last three months of the year. Much of December’s drop in retail sales came from falling gasoline prices, which have tumbled to a nationwide average of $1.79 a gallon from their peaks of $4.11 in July. Sales at gas stations fell 15.9 percent from November to December, and were down more than 35 percent from December 2007.

But even excluding gasoline and automobiles, retail sales dropped by 1.5 percent for the month, said James O’Sullivan, senior economist at UBS. “It was a pretty broad-based decline,” he said. The government’s figures were the latest confirmation of a bleak holiday shopping season.Sales for retailers during the holidays were particularly weak, reflected in the wave of retail bankruptcies in the last few weeks. Last week, an industry group reported that retail sales had fallen 2.2 percent in November and December from a year earlier, and that some of the most widely known brands in America had suffered even worse declines.

Department stores including Nordstrom, Sak’s and Nieman Marcus reported double-digit percentage drops since last year. Abercrombie and Fitch was down by 24 percent and J.C. Penney by 8.1 percent, and even Wal-Mart missed analysts’ expectations and cut its outlook for the months ahead. And the months ahead will be difficult. January is typically a slow month for retailers, and the significance of a December sales decline is far greater than a drop-off in January because sales in November and December account for 25 to 40 percent of many retailers’ annual sales, according to the National Retail Federation, an industry group.

Ben Bernanke, chairman of the US Federal Reserve, warned yesterday that the economic recovery package planned by the incoming Obama administration will not succeed unless financial stability is restored. Mr Bernanke used a speech in London to issue a clear challenge to the US president-elect, Barack Obama, who is planning a huge fiscal stimulus – expected to be worth $775bn (£535bn) – to get the US economy going again.

He said: "Fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilise and strengthen the financial system." Delivering the Stamp Lecture at the London School of Economics, Mr Bernanke spelt out what those "further measures" might entail. They include further recapitalisations of financial institutions; purchases of "toxic debts" under the troubled assets relief programme (the Tarp), or government guarantees of their value; purchases of commercial paper, and, possibly, government securities; and a clear signal that "economic conditions are likely to warrant an unusually low federal funds rate for some time".

The Fed has already announced its intention to buy $600bn worth of Fannie Mae and Freddie Mac debt and mortgage-backed securities. In addition, the possibility of a "bad Bank" was floated yesterday by Mr Bernanke. This would purchase assets from financial institutions in exchange for cash and equity in the new vehicle. However, the commercial banks would never again be allowed to become "too big to fail", the Fed's chairman added. "It is unacceptable that large firms that the government is now compelled to support to preserve financial stability were among the greatest risk-takers during the boom period... they must accept especially close regulatory scrutiny of their risk-taking."

Mr Bernanke's remarks were echoed by those given in evidence to a Treasury Select Committee hearing on the banking crisis and its effects on the UK. Jon Moulton, founder of Alchemy Partners, told MPs on the committee that the banks had become "too damn complicated" and impossible to regulate or manage. He called for "narrow banks" to get back to the absolute basic activities of the sector. Mr Moulton also berated the ambition of the new business loan guarantee scheme, set to be unveiled by the Government today. He said: "Twenty billion pounds is not actually a very large number against the scale of the problems we're talking about.

"I would personally be happy if the scheme was a lot larger – it offends many of my basic principles, but we are in a bad hole and we need to get out of that hole." Richard Lambert, the director general of the CBI, said the emphasis should now be on lending to larger companies. "Wholesale markets are frozen and I think there is particular reason to be concerned about the refinancing needs of larger companies who need a syndicate to take them through, and are finding it noticeably harder," he warned. "It's going to be appropriate for the taxpayer to take on more credit risk."

Mr Lambert, Mr Moulton and other witnesses urged the Government to "print money", while Mr Bernanke also spoke openly about the Fed's plans to implement a policy of "quantitative easing", though the Fed chairman prefers the term "credit easing". The policy would not be inflationary, he said, because the "vast majority of banks are choosing to leave their excess reserves idle, in most cases on deposit with the Fed". The Fed could "unwind" its positions relatively quickly, though the mortgage-backed securities would probably be retained for longer, he added.

The calls for action came amid further signs that the global economic slowdown is intensifying. In its annual global risk report, the World Econ-omic Forum, which is best known for its annual gathering in Davos, Switzerland, said that the international economy is threatened by Western governments' worsening public finances and a further collapse in asset prices as the financial crisis continues to take its toll. The credit ratings agency Standard & Poor's yesterday issued a more pessimistic verdict on Portuguese sovereign debt, which joins Ireland, Spain and Greece in the euro-delinquents club, shaking confidence in the single currency. The WEF added that China faced major difficulties, with growth set to drop below 6 per cent, a slowdown that would make global economic conditions much worse.

Federal Reserve chief Ben Bernanke on Tuesday suggested the incoming Obama administration may want to retool the government's approach to fighting the credit crisis and tap a $700 billion financial rescue fund to sop up bad assets on the books of banks. In his first policy speech since early December, Bernanke said that while an expected U.S. fiscal stimulus package could provide a "significant boost" to the economy, the government may need to inject more capital into banks and consider steps to clear the financial system of toxic mortgage-related debt. "Fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system," Bernanke said at the London School of Economics.

U.S. President-elect Barack Obama, who takes office in a week, is pressing a skeptical Congress to let his Treasury Department access the remaining $350 billion. Bernanke said the government could consider using the money to buy up bad debt, as originally intended, or could offer asset guarantees or set up a so-called bad bank to take over the assets as a way to strengthen a shattered financial system and help the U.S. economy pull out of its year-long recession. "The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending," Bernanke said.

John Bovenzi, chief operating officer for the Federal Deposit Insurance Corp, told a congressional panel removing bad assets from bank balance sheets should be "a key component" of how the final $350 billion in bailout funds is used. A rising tide of U.S. mortgage delinquencies has saddled the global banking system with distressed assets, choking off lending and sending many economies tumbling. Outgoing U.S. Treasury Secretary Henry Paulson and Bernanke had pressed Congress in September to approve the $700 billion bailout fund so the government could buy up the bad debts to stave off a financial calamity. Paulson, however, quickly turned his focus toward purchasing equity in banks, which he has argued was a quicker way to shore up the system.

Bernanke said how governments respond to the financial crisis would determine the timing and strength of recovery, and he stressed that the Fed still had 'powerful tools' to deploy even though it has cut benchmark interest rates to near zero. When the U.S. central bank dropped overnight rates to a range of zero to 0.25 percent in December, it said monetary policy would now focus on the size of its balance sheet, which has exploded as officials pumped funds into stressed markets. Analysts have said the Fed's policy marks a form of 'quantitative easing' of the sort Japan employed earlier this decade to break free of a persistent deflation. Bernanke, however, sought to differentiate the Fed's "credit-easing" approach with the policy pursued in Japan.

"The Federal Reserve's credit-easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for businesses and households," he said. In contrast, the Bank of Japan focused on the quantity of bank reserves. This difference means the U.S. strategy does not lend itself to targeting the quantity of excess bank reserves or the money supply, Bernanke said. In outlining the Fed's emergency tools, Bernanke said a program to support consumer and small business credit, which will begin providing loans to investors next month, could be expanded or widened to cover additional classes of securities. He also reiterated that the Fed was considering buying longer-term government debt.

Some analysts have warned that the Fed's aggressive efforts may end up fueling inflation. Bernanke, however, played down that concern, noting that many of the Fed's lending facilities will wind down as demand for the money winds down. With many of the assets held short-term in nature, a "significant shrinking" of the Fed's balance sheet could happen quickly, he said. "We see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate," Bernanke said. In answer to a question, Bernanke said he was expecting the economy to stabilize later this year, but suggested it could take longer for the labor-market to heal. "I am hopeful that later in 2009, depending on factors, particularly including financial and credit markets, we should begin to see some stabilization in the economy. It takes a while though for labor markets to recover."

Ben Bernanke, chairman of the US Federal Reserve, has begun to sketch an "exit strategy" for the first time after embarking on the most radical monetary experiment in US history, insisting that huge infusions of money will fuel inflation once recovery starts. Speaking to an audience at the London School of Economics, he said drastic action by governments this Autumn had stopped the crisis from spiralling out of control. "Those measures likely prevented a global financial meltdown that, had it occured, would have left the global economy in far worse condition than it is today," he said. There are moments of such danger that the only priority is to avert disaster, and this was it. "Put out the fire first, and then think about the fire code," he said.

But Mr Bernanke is acutely aware of critics who fear that the Fed is storing up trouble by "printing money" and stoking a Zimbabwe-style surge in the US monetary base. "At some point, the Federal Reserve will have to unwind its various lending programmes," he said. This will happen in an orderly fashion. The excess liquidity poses no inflation threat because the "great bulk" is lying idle on deposit at the Fed. It will be mopped up "automatically" as markets revive. Money lent to banks or used to prop up the commercial paper market is mostly on a short-term basis, so contracts will expire anyway. Mr Bernanke gave his blessing to the $800bn (£550bn) fiscal package of the Obama team, calling it a "significant boost" to the economy as it battles a virulent downturn, but said action on broader front would be needed.

"Fiscal policy can stimulate economic activity, but a sustained recovery will require a comprehensive plan to restore normal flows of credit. History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively," he said. He said the Fed is mulling plans to buy US Treasury debt - a move regarded as a dangerous step for any central bank - and suggested a revival of the original 'TARP' scheme passed by Congress to mop up toxic securities. His version calls for "bad banks" created to "purchase assets from financial institutions in exchange for cash and equity".

In remarks in London today, Fed Chair Ben Bernanke let the world know how he views the risks and benefits of the recent dramatic changes in the assets and liabilities of the U.S. Federal Reserve.One of Bernanke's goals was to reassure the public that the many new loans that the Fed is extending and assets it is purchasing do not pose a significant risk to taxpayers. From Bernanke's remarks:

Importantly, the provision of credit to financial institutions exposes the Federal Reserve to only minimal credit risk; the loans that we make to banks and primary dealers through our various facilities are generally overcollateralized and made with recourse to the borrowing firm. The Federal Reserve has never suffered any losses in the course of its normal lending to banks and, now, to primary dealers.

Left unsaid here is the fact any private lender could equally well have also extended said overcollateralized loans to these same borrowing institutions, but decided that the compensation for absorbing such a risk was inadequate. Bernanke's core assumption is thus that private lenders are currently mispricing risk, but the Fed can do it correctly. I'm prepared to believe that's true-- there is some degree of overcollateralization that might be inadequate for markets but should be sufficient for the Fed, but what is it? Are the underlying assets really worth 99 cents, 90 cents, or 50 cents on the dollar? Should the overcollateralization therefore be 1%? 10%? 100%? The devil is in the details, and whatever details we know about this aren't coming from the Fed.

Nor do I take comfort in Bernanke's observation that the Fed hasn't lost any money on the new facilities-- yet. Didn't the buyers of subprime MBS say the same thing? It was the wrong answer then for the same reason it's the wrong answer now-- when you drastically change the scale and rules of the game, you can't base your risk assessment on historical performance. The one thing of which we should be confident at the moment is that the future won't look like the past. Bernanke also discussed some of the Fed's new plans:

In addition, the Federal Reserve and the Treasury have jointly announced a facility that will lend against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. The Federal Reserve's credit risk exposure in the latter facility will be minimal, because the collateral will be subject to a "haircut" and the Treasury is providing $20 billion of capital as supplementary loss protection. We expect this facility to be operational next month.

Here at least we have a number-- $20 billion-- that will give us some idea of what Bernanke assesses the ballpark risks to be. If, for example, we see that the Fed lends $100 billion in this program, I'd take that to mean he's thinking the underlying assets are really worth at least 80 cents on the dollar; if $200 billion, we're talking about 90 cents on the dollar. If this gets into the hundreds of billions, it's hard to see how $20 billion would be regarded as a significant equity cushion.Bernanke also addressed the question of what's the exit plan for bringing the Fed's balance sheet back to normal size and safety:

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities.... As lending programs are scaled back, the size of the Federal Reserve's balance sheet will decline, implying a reduction in excess reserves and the monetary base.

A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds-- including loans to financial institutions, currency swaps, and purchases of commercial paper-- are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy-- namely, by setting a target for the federal funds rate.

That sounds to me like an exit strategy for how to get out of this if everything works out just right and the problems all go away. And what's the exit strategy if it doesn't work? I suppose more lending facilities.

Tested before taking power, President-elect Barack Obama privately delivered a pre-inauguration veto threat to fellow Democrats on Tuesday, saying they would not deny him use of the remaining $350 billion in federal bailout funds. Obama coupled his threat with a promise to revise elements of the original bailout program that have drawn widespread criticism, pledging that billions will go toward helping homeowners facing foreclosure. Several Democrats said his commitments, to be made in writing, would be enough to prevent an embarrassing pre-inauguration drubbing for the president-elect when the Senate votes this week. "This will be the first vote that President-elect Obama is asking us for. I'll be shocked and I'll be really disappointed if he doesn't get it," said Sen. Joseph Lieberman, an independent Democrat from Connecticut. "This is a new beginning."

Behind closed doors, Obama also urged lawmakers to act quickly on the massive economic stimulus measure that his aides have been negotiating with congressional officials. The legislation will blend federal spending with tax cuts, and could reach $1 trillion in size, a measure of the nation's economic woes. Several Democratic officials described a bill very much in flux. They said lawmakers were discussing allocating as much as $80 billion over two years to help shield schools from the impact of state budget cuts and roughly $40 billion for traditional anti-recession transportation programs such as highway and bridge construction. Additionally, they added that there was money tentatively set aside to fund a $25-a-week increase in unemployment benefits as well as a 15 percent boost in food stamp benefits. There was support in the Senate for funds to upgrade military barracks, as well. The officials spoke on condition of anonymity, saying they were not authorized to disclose details.

Democratic leaders in the House and Senate hope to have the legislation ready for Obama's signature by mid-February, and House Speaker Nancy Pelosi and Senate Majority Leader Harry Reid, D-Nev., held a late-afternoon meeting on it. "We've made great progress, and we fully intend to meet our deadline," Pelosi, D-Calif., told reporters. She disclosed no details. For Obama, attendance at the Democrats' weekly closed-door lunch was a homecoming of sorts, a return to the Capitol where he arrived as a newly elected senator only four years ago. Reid called it a "lovefest," and said the president-elect was greeted with a five-minute ovation by Democrats happy to have the White House back after eight years of Republican rule. Sen. Carl Levin said the session had a sentimental tone at times, despite the magnitude of the nation's economic woes and the challenge Obama and fellow Democrats confront.

"It's kind of hard not to call him, 'Barack.' So he said, `Call me Barack for the next couple of days,'" Levin said with a smile. Separately, Obama's nominee as budget director, Peter Orszag, said at his confirmation hearing that even after the economy recovers, annual deficits could reach $750 billion or so and steadily exceed $1 trillion by the end of the next decade. The president-elect has pledged to make deficit-reduction a priority, but says economic recovery must come first. Despite its size, the economic stimulus bill is not expected to face heavy opposition among Democrats, and Obama has won praise from Republicans for showing a willingness to show deference to their concerns. Senate Republican leader Mitch McConnell, R-Ky., floated a new proposal, raising the possibility of a two-year elimination of Social Security payroll taxes.

Obama got a boost during the day from Federal Reserve Chairman Ben Bernanke, who said in a speech in London that the emerging legislation could provide a "significant boost" to the sinking economy. Bernanke also warned in remarks prepared for the London School of Economics that a recovery wouldn't last unless other steps were taken to stabilize the shaky financial system. There was plenty of controversy surrounding Obama's decision to tap the $350 billion remaining from the financial bailout program that Congress created last fall, when the nation's credit markets ceased working and plunged an already weak economy into a tailspin. President George W. Bush, acting at Obama's request, formally notified Congress on Monday that Treasury wanted to use the funds, but Congress can vote to block the move.

"It is clear that the financial system, although improved from where it was in September, is still fragile," the president-elect said Monday, making the case for use of the funds. There was an element of political theater to the day's events. It is a foregone conclusion that Obama will be able to make use of the money as he tries to improve the economy. He could veto anti-bailout legislation if it came to that, and there are more than enough votes to uphold him. "He said if for some reason it passed, he would veto it," Lieberman said. But neither the president-elect nor fellow Democrats are eager to see that unfold, fearing it could damage Obama politically even before he takes the oath of office as the 44th president next Tuesday. "I don't think that's the way you start out a presidency," said Sen. Jay Rockefeller, D-W.Va.

Several Democrats said they found Obama persuasive, but added that they would wait to see his formal commitments. "I feel much better," said Sen. Claire McCaskill, D-Mo., noting the president-elect's commitment to rectify several elements of the existing program. Levin said Obama promised his administration would do a better job of accounting for how the money was disbursed, would make sure none of it went to pay for stockholder dividends, would enforce restrictions on the pay of corporate executives and more. He also said the president-elect had pledged to honor the commitments the Bush administration had made to prop up the beleaguered domestic auto industry.

It is not clear how much of the money will go toward helping hard-pressed homeowners, but in the House, Democrats were drafting legislation that would dedicate a minimum of $40 billion to that effort. "If we do not get the second $350 billion, I do not see any way that we can get substantial foreclosure relief," said Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee. The housing measure is tentatively scheduled to come to a vote in the House on Thursday. Rep. Spencer Bachus of Alabama, the committee's ranking Republican, questioned whether the money was necessary. The fund is becoming "a grab-bag where people can just reach in and get taxpayer money," he said.

President Obama could not find any economists who were able to see the housing bubble for his economic team. Fortunately, he indicated that he would be willing to listen to those of us who did in designing his stimulus package. In response to his request for ideas on how to make his economic recovery package more effective, I have put together the following list of seven proposals. This is a mix or match list, intended to be added to the list of items already suggested, although given the severity of the downturn, all of them could probably be included without causing concern about excessive deficits.

1) Extend Health InsuranceOffer a $2,000 tax credit for any firm that gives health insurance to employees not currently covered. Match at a 70 percent rate any improvements in health care coverage (e.g. lower employee premiums) up to $1,000. If 20 million workers get coverage, this will cost $40 billion a year. If another 50 million workers get added benefits that average $800 per year, this will cost the government another $28 billion for a total cost of $68 billion a year. This would be a great first step towards universal coverage. If President Obama also allowed employers and individuals to buy into a Medicare-type public plan, then he will have gone a long way towards reforming the health care system.

2) Publicly Funded Clinical TrialsStart a system of publicly funded clinical trials. The point would be to take the conduct of trials out of the control of the drug industry so that doctors and researchers would have immediate and full access to all research findings. As a quid pro quo for paying for the trials, the government would get control of the licensing of the patent. The drugs developed through this system would all be sold as generics costing somewhere near $4 apiece at Wal-Mart. The payback from this would be enormous, instead of spending $330 billion a year on prescription drugs in 2012, we might spend closer to $30 billion. We'll be paying $30 billion a year or so for clinical trials, and maybe close to that much in licensing fees, and getting much better medicine. And, as a side benefit, people in developing countries would get cheap drugs too. We could put an end to "free-trade" agreements that try to jack up drug prices in poor countries through stronger patent protections. Total cost: $30 billion a year.

3) Cash for ClunkersPrinceton economist Alan Blinder recently argued in the NYT for a program of buying back older, more-polluting cars at a premium over their book value. This would get the most-polluting cars off the road (raising average full efficiency) and put some money into the pockets of the people who own them. Most of these car owners will have low and moderate income, so we will be putting cash into the hands of people who need it and will spend it. Blinder calculated that we get 5 million older cars a year off the road for a cost of less than $20 billion a year.

4) Subsidies for Public TransportationPeople in the United States take more than 10 billion trips on public transportation each year. This has enormous environmental benefits. Not only are these people consuming much less energy by using public transit, by not driving themselves, they are reducing congestion, and therefore reducing the amount of energy wasted in traffic jams. The government can encourage public transit and get money into the pockets of the people who use it (disproportionately low- and moderate-income people), by giving a $1 subsidy for each trip that gets directly passed on in lower fares. For someone taking a subway or bus twice a day, this will amount to savings of $500 a year. The government can include some additional funding to buy more buses and train cars. The cost would be approximately $13 billion a year.

5) Funding for Writers/Artists/Creative WorkersIn the New Deal there was both a federal arts project and a federal writers project. These programs employed thousands of young artists and writers. A creative stimulus package can extend this idea for the Internet Age. Suppose that President Obama made $10 billion a year available for state and local governments to support various types of creative and artistic work. This could include music, movies, writing books, even journalism. The one condition for support is that all material be made freely available in the public domain. (Better yet, it could have copyleft protection.) This funding would be sufficient to employ 200,000 people a year at an average of $50,000 each. This would put an enormous amount of creative work in the public domain that people all over the world could download at zero cost. In the first year or two, we could have this program administered through public agencies, but in later years we can have people choose for themselves which work they want to support through a tax credit. The cost would be approximately $10 billion a year.

6) Funding for the Development of Open SoftwareIn the same vein, the government can spend $2 billion a year to develop open source software. This money can be used to further develop and simplify open source operating systems such as Linux, as well other forms of free software. The payoffs from this spending would be enormous. Imagine that every computer buyer in the world would be able to get a computer for which the operating system was free, as was almost all the software that they would ever use. This would surely save consumers an average of at least $200 per computer. With sales at close to 20 million a year, the savings in the United States alone could easily exceed the cost of supporting software development. Adding in the benefits (and presumably some contributions) from the rest of the world, we will be way ahead by going the route of publicly funded open software open software. The cost would be $2 billion a year.

7) Pay for Shorter Workweeks and More VacationsThe United States lags the rest of world in that its workers are not guaranteed any vacation time, sick leave or family and parental leave. In Europe, five or six weeks a year of paid vacation is standard. Also, all West European countries guarantee their workers some amount of paid sick leave and paid parental leave. The stimulus gives us a great chance to catch up with the rest of the world. The government could give make up the pay for two years for any paid cutback in hours, up to 10 percent of total hours worked in a year and $3,000 per worker. This means that if a firm offered workers who previously had no paid vacation, five weeks of vacation a year, the government would provide a tax credit to pick up the tab, up to $3,000 per worker. Similarly, if they extended 10 days of paid sick leave, the government would provide a tax credit for the amount actually used. If employers of 70 million workers (half of the labor force) received an average tax break of $2,500, the cost would be $170 billion a year.

There are undoubtedly other items that should be added to this list. As President Obama's chief of staff, Rahm Emanuel, said, we should not allow this crisis to be wasted. We should not be trying to just bring the economy back to where it was before the housing bubble crashed. Rather, we should be looking to create a cleaner, fairer, better country. Not all of it will be accomplished with the initial stimulus package. Not everything will even be accomplished in President Obama's first term. The real question is whether the country can do better than the modest stimulus package that has been laid out thus far. President Obama knows that we can.

State and local governments would benefit from more than $160 billion in federal aid under a plan pushed by House Democratic leaders in negotiations over the economic-recovery package taking shape on Capitol Hill. The House has taken the lead on the issue in closed-door discussions on the broader recovery package, which is sought by President-elect Barack Obama and is expected to have an overall price tag approaching $800 billion. Individuals familiar with the proposed state assistance said the broad outlines are likely to be accepted by the Senate, which is working on a plan of similar scope, as well as the incoming Obama administration.

Under the plan, some $80 billion would be steered toward a new "education stabilization fund," which would be used to help states avoid cutbacks in teachers and classroom programs. An additional $87 billion would be set aside for Medicaid, the federal-state program that helps low-income families and is facing budget constraints. A further $3 billion would be spent on certain Medicaid regulatory initiatives. The state aid has long been a priority of Speaker Nancy Pelosi and would represent a substantial share of the roughly $500 billion in spending envisioned for the broader recovery package.

Beyond aid to states, the spending package will include investments in renewable energy, such as wind and solar power, and highway and bridge construction. It will be paired with $300 billion in tax cuts for businesses and individuals. Action on the package, which Mr. Obama says is needed to jolt the economy back to life, will begin publicly in the House and Senate shortly after Mr. Obama takes office next week.

Several states are considering the rare step of raising gasoline taxes to help fill growing budget gaps and potholed roads.Politicians in California, Massachusetts, New Hampshire, Illinois and Oregon, for example, are introducing bills that would raise gasoline taxes for road and bridge repair, as state legislatures around the country begin their new sessions. In Iowa, top legislators in both houses would support an increase. And in Ohio, a state task force last week recommended raising the gas tax by 13 cents a gallon. There are political risks in raising taxes of any kind, and legislators have been loath to raise their gas taxes, which are imposed in every state but Alaska. In many states, gas taxes have not been raised for more than a decade and they often are not indexed to inflation.

“I’ve opposed virtually every revenue enhancer in terms of tax increases up to this point,” said John E. Bradley, an Illinois state representative who is chairman of the House Revenue Committee. This year, he is introducing a bill with a motor-fuel surcharge of 8 cents a gallon. He was persuaded to change his stance, he said, because of the urgent needs of Illinois roads and highways. State lawmakers clearly see an opportunity to push through a tax. The recent sharp drop in gasoline prices, to less than half of last summer’s high of more than $4 a gallon, means that drivers may be less hesitant to pay slightly higher prices. For states, acute revenue shortfalls, combined with years of rising construction costs and a backlog of projects, are forcing difficult choices between raising taxes or imposing drastic cuts.

“Do you cut snowplowing? Do you cut salting roads? Do you cut maintaining and fixing bridges?” asked Representative David B. Campbell, of New Hampshire, vice chairman of the House Public Works and Highways Committee. He is introducing a bill to raise the state gasoline tax by 15 cents a gallon over three years, which would help close what he says could become a cumulative $1 billion hole in the state Transportation Department’s budget over 10 years. The gasoline tax in New Hampshire has not been raised since 1991. As of last October, the average state tax was 30 cents a gallon, led by California at 48.7 cents, according to the American Petroleum Institute. The federal government also takes a flat 18.4 cents at the pump, a number that has not budged in essentially 16 years.

The National Commission on Surface Transportation Infrastructure Financing, a federal group that analyzes future highway and transit needs, is expected soon to release a report to Congress that includes a recommendation to raise the federal gasoline tax by 10 cents a gallon. It also will recommend raising the federal tax on diesel fuel. (States have diesel fuel taxes as well.) Half of highway funds for states come from state and federal gasoline tax revenues, according to a pending National Governors Association report. (The federal tax is routed through the federal Highway Trust Fund, with about 20 percent of that going to mass transit.) The rest of state highway funds come from a variety of sources, like tolls, vehicle registration fees, bonds and general funds. Compounding the budget problems for states is the fact that people are driving less, in large part because of the weakening economy and last year’s high gasoline prices. Last October, Americans traveled 3.5 percent fewer miles, on average, compared with a year earlier, according to the federal Department of Transportation.

When people drive less, and buy fuel-efficient cars like the Toyota Prius, they buy less gas, causing gas-tax revenues to fall. In Georgia, for example, motor fuel tax revenues fell 10.4 percent, or $8.8 million, in December 2008 compared with a year earlier. Even the federal government has been left short of highway funds. Last fall, Congress provided $8 billion in emergency funds to the Highway Trust Fund, which distributes federal gas tax revenue to the states, because of rising costs and shrinking revenue as Americans drove less. States are hoping that President-elect Barack Obama will make good on his promise of huge stimulus spending on roads and bridges. Many states have already submitted wish lists.

In California, both Gov. Arnold Schwarzenegger, a Republican, and Democratic lawmakers are prepared to raise the gasoline tax, last directly raised in 1994. But they disagree on the means. The governor’s proposal would indirectly raise the tax as part of an overall sales tax increase, for an effective gasoline tax rise of about 3 cents a gallon (which could later rise if fuel prices rise). The proposal by the Democrats, recently rejected by Governor Schwarzenegger, would change the structure of gasoline taxes and result in an increase of 8 to 9 cents a gallon. “It is the first time anybody has talked about this in some time,” said John White, executive director of the Center for Energy Efficiency and Renewable Technologies, based in Sacramento.

In Massachusetts, which still needs to pay off debt from Boston’s Big Dig, a debate is under way over whether to impose higher tolls, which Gov. Deval Patrick has said he was willing to support, or higher gasoline taxes, which some state lawmakers are discussing. Governor Patrick has also indicated that he is conditionally open to supporting an increase in gasoline taxes. Naturally, legislators proposing higher gas taxes are certain to face some opposition. “One of the biggest economic drivers for New Hampshire is tourism, and we feel this may have a negative impact,” said Timothy G. Sink, president of the Greater Concord Chamber of Commerce.

He is worried that gas prices could rise again, so the tax would just add to the driver’s burden. “Who’s got the crystal ball to tell us what’s going to happen in the next two years?” he said. The chamber has not taken an official position on the tax, he said. And with the advent of more fuel-efficient vehicles — including hybrids and all-electric cars that some automakers are now promising to bring to market — some states are rethinking the traditional gas tax. North Carolina and Ohio, among others, are starting to consider the concept of a tax on “vehicle miles traveled.” That system has been tried on a small pilot scale in the Portland, Ore., area, but has never been tried on a large scale.

Citigroup chief executive Vikram Pandit is preparing to break-up the banking conglomerate, separating its assets into essentially a separate “good” and “bad” bank in a startling reversal of the bank’s decade-old strategy as a universal bank. Mr Pandit is understood to have decided that it is now necessary to place Citigroup’s investment bank and its US consumer finance arm into what will essentially be a “bad bank,” with the remainder’s focus being the commercial and retail bank which formed the core of the old Citicorp. Although the bad bank, which will contain around $700bn (£482bn) of assets, will remain within the legal confines of Citigroup, its results will be reported separately and its access to capital will be limited.

In addition, once core businesses such as its US insurance arm Primerica will be sold off. The decision, in response to the company’s increasing lack of capital, is a clear U-turn by Mr Pandit, who as recently as mid-November said that he believed in the “financial supermarket” model. An announcement on his plan, which is still being developed, is expected to be made by Mr Pandit either ahead of or alongside the bank’s fourth-quarter results, scheduled for release on January 22. The first step in the break-up came last night as Citigroup announced the sale of its broking division into a joint venture with Morgan Stanley.

The new business, Morgan Stanley Smith Barney, will contain over 20,000 financial advisors – including those operating under the Quilter brand in the UK – managing more than $1,700bn in client assets. Citigroup is to receive $2.7bn and will own 49pc of the venture, with Morgan Stanley owning the majority. After three years, Citigroup will be able to sell down its stake but will retain a significant stake for at least five years. Shares in Citigroup, which had fallen 22pc in the prior two trading days, closed up 30 cents at $5.90.

Vikram Pandit may soon be forced to carve up Citi to plug the hole in its balance sheet from what could be as much as $150 billion in toxic assets. Even before the ink was dry on the deal merging Morgan Stanley (MS) and Citigroup's brokerage operations, talk surfaced of more radical changes at Citigroup (C). It's not known exactly what Citi, which pioneered the concept of the financial supermarket, will look like. But it's quickly becoming clear it will be a whole lot different from the institution initially conceived back in 1998 when Citicorp and Travelers Group were merged to form Citigroup.

With the brokerage sold, Primerica, largely an insurance operation, is on the chopping block, according to a source familiar with the discussions. So are some of the bank's proprietary trading operations, the same ones that bulked up on the toxic real estate-related securities now making Citi's balance sheet sick. Broadly speaking, the bank will still have consumer, commercial, and investment banking operations, according to the source. Citi will also hold on to its private bank, which caters to the mass affluent. (An announcement with explicit details isn't expected until the bank's earnings call on Jan. 22.) The changes now afoot contradict what CEO Vikram Pandit has been telling the market for months—that he wouldn't split up Citi. But as the economic and credit climate has deteriorated, the government—Citi's largest shareholder, with a 7% stake—is likely nudging Pandit to shift his strategy and raise more capital.

And the 52-year-old executive has little choice but to follow orders. Citi isn't the only bank in need of fresh cash. Federal Reserve Chairman Ben Bernanke said in a speech to the London School of Economics on Jan. 13 that the government will probably need to inject more capital into the banking system. Additionally, the Fed may need to backstop more toxic assets—as it did with Citi back in November—"to ensure stability and the normalization of credit markets." All of Citi's recent posturing may be obfuscating the real issue: the bank's portfolio of toxic assets, which is becoming increasingly troublesome. While Citi gets a $6 billion aftertax gain from the joint venture, it does nothing to alleviate the problems in that portfolio. According to some estimates, the toxic assets on the books—consumer, corporate, and leveraged loans—could stand at $150 billion. "The hole in the balance sheet is the problem," says a senior executive at a financial firm that specializes in fixed-income securities.

So what will happen between now and the bank's earnings conference on Jan. 22? Some market observers suspect the government will directly buy up Citi's assets or provide a backstop for all the toxic securities on the books. In effect, such action will mirror the original intent of TARP, the Troubled Assets Relief Program, as first drafted last summer. "TARP was designed first to restore the secondary market, which was far more important," says Robert B. Albertson, chief strategist at Sandler O'Neill + Partners, a boutique financial services investment bank in New York. "It is economic quicksand to give or lend banks the money now." Others say the government needs to take more drastic action, taking Citi into receivership, wiping out equity and likely debt-holders in the process. Then, the government would need to carve out the bad assets into a separate entity, following the good bank-bad bank structures set up in the wake of the savings & loan crisis in the early 1990s.

"Until you separate those toxic assets and put a bottom to the pricing and trading of those instruments," the market will be in no-man's-land, says Tom Barrack of money manager Colony Capital. Barrack believes the government will act in this way because he has seen it happen before. After the S&L crisis, Barrack's firm bought American Savings, a failing thrift the federal government had seized and chopped into the bad bank-good bank structure. "I am a big fan of Hank Paulson, but TARP has been an abject failure," says Barrack. "I compare the situation to a fire on a Savannah Plain: Let it rip and burn, and the market will rejuvenate so much faster—try to control or impede it, and there will be more and longer suffering before renewal. Japan experienced two decades of economic paralysis by experimenting with fire control of a similar unproductive sort."

Vikram Pandit is unraveling his empire to save his bank. Citigroup Inc.’s chief executive officer said yesterday he would cede control of the Smith Barney brokerage to Morgan Stanley. Pandit may also dump the CitiFinancial consumer-lending unit, tag Tokyo-based Nikko Asset Management Co. for eventual sale and rein in trading with the bank’s own capital, people familiar with the matter said. Pandit, who turns 52 today, spent 13 months on the job trying to integrate a New York-based behemoth assembled by predecessors Sanford “Sandy” Weill and Charles O. “Chuck” Prince. Yet he incurred $20 billion of net losses and was forced to accept $45 billion of rescue funds from the U.S. government.

Now, he’s slicing off divisions of a company he described six months ago as “a truly global universal bank.” The financial-supermarket model “was never going to work,” said Bill Smith, founder of Citigroup shareholder Smith Asset Management Inc. in New York, who has repeatedly called for a breakup. “You had three management teams that all failed to integrate this. You will not recognize this company within 12 months.”

The bank’s remaining parts will include branch banking, advising on mergers, underwriting securities, processing payments, corporate lending and handling trades for clients, the people said. Citigroup will keep its international reach, maintaining the “globality” that Pandit said last year was the bank’s defining strength. “It will be a much more manageable business,” Marshall Front, chairman of Barnett Associates LLC, said in a Bloomberg TV interview yesterday. The bank, scheduled to report fourth-quarter results next week, will probably say it lost $2.6 billion, based on the average estimate of six analysts surveyed by Bloomberg. Oppenheimer & Co. analyst Meredith Whitney estimated in a Nov. 24 note to clients that Citigroup may have a $12.4 billion net loss in 2009.

Citigroup traces its history to 1812, with the founding of the City Bank of New York. Its current incarnation took shape in 1998 with the $37.4 billion merger of Travelers Group Inc., led by Weill, and John Reed’s Citicorp. Travelers, which owned brokerage Smith Barney Holdings Inc., had a year earlier paid about $9 billion for Salomon Inc., the parent of Salomon Brothers Inc., to form Salomon Smith Barney Inc.

On a visit to Weill’s midtown-Manhattan office last year, Weill showed off a framed chart of the stock performance under his leadership. From the initial public offering of Commercial Credit Corp., the 97-year-old consumer lender that Weill took control of in 1986, until his retirement as Citigroup’s CEO in 2003, the chart showed a return of 2,699 percent -- beating the 2,588 percent return of Warren Buffett’s Berkshire Hathaway Inc. More recently, as the credit crisis erupted, Citigroup stock has reversed course. A 47 percent decline in 2007 and 77 percent drop last year made it the worst performer for two years running among large U.S. banks, as measured by the KBW Bank Index.

Already this year, the stock is down 12 percent. It rose 30 cents yesterday to $5.90 in New York Stock Exchange composite trading. Some current and former Citigroup executives place the blame for the firm’s troubles on Weill. He refused to spend enough on technology and failed to integrate the new companies he acquired, say people familiar with the matter. CitiFinancial, a global network of 3,799 branches that offers car loans, home-equity lines and personal “debt- consolidation” loans to repay credit cards and other bills, didn’t have software to enable salespeople to offer an array of credit cards to customers, a person familiar with the operation said last year.

The bank’s computer networks are redundant, the result of the bank’s failure to integrate acquisitions, Chief Administrator Don Callahan said last year. Pandit’s initial plan was to complete the integration that Weill and Prince left undone. “Each business has been operating with its own back office,” Pandit told investors and analysts gathered in New York on May 9. “We have 140,000 people in IT and operations. We have 16 database standards. We have 25,000 developers. This results not only in waste but doesn’t give us any opportunity to leverage our organization. That’s massively inefficient. We’re finally going to merge it all.”

Richard Bove, an analyst at Lutz, Florida-based Ladenburg Thalmann Financial Services Inc., said it would take at least five years. Pandit ran out of time after subprime mortgage-bond writedowns and surging costs to cover defaulting mortgages and credit-card loans sent the stock to a 15-year-low of $3.77 in November and forced the bank to accept a second round of government bailout funds. Born in Nagpur, in the central Indian state of Maharashtra, on Jan. 14, 1957, Pandit has a doctorate in finance from Columbia University. He joined Morgan Stanley in 1983 and climbed through the ranks as an investment banker and executive until he was ousted in a power struggle in 2005.

After taking over at Citigroup in December 2007, he pored over histories of Citigroup dating to the turn of the 20th century and watched videotapes of the late Walter Wriston, Citibank’s CEO from 1967 to 1984. Citigroup’s international banking empire encompasses 106 countries and accounted for more than half of its $81.7 billion revenue in 2007. Pandit last May said the company could right itself by paring $500 billion of loans and bonds from a balance sheet that ballooned by 45 percent, to $2.2 trillion, from 2005 to 2007. He has sold at least 21 businesses, including its German consumer and an Indian processing business with 12,000 employees.

That wasn’t enough. In November, he pledged to cut 52,000 jobs, including 26,000 through divestitures. Pandit was forced to loosen ties to Smith Barney, a business that has been at the hub of the modern Citigroup because brokers interacted with most of the parts. Stocks from the trading and underwriting desks could be sold to clients; individuals could entrust their investments to the bank’s hedge- fund managers; and brokers could recruit new customers from among the ranks of banking clients.

In the deal with Morgan Stanley, Citigroup will retain 49 percent of a joint venture that will combine the two firms’ retail-brokerage operations. Citigroup also will get a $2.7 billion payment from Morgan Stanley and get a $5.8 billion after-tax gain that will bolster capital. In May, Pandit revived a variation of Citigroup’s 1970s tag line “The Citi Never Sleeps,” which originally referred to the bank’s then-innovative network of New York automated teller machines. The revised slogan, “Citi Never Sleeps,” is now featured in the company’s advertising campaigns worldwide. As even more losses loom next week, it may be some time before Pandit himself gets some sleep.

Thousands of U.S. banks are waiting for federal investment dollars, but the Obama administration needs to set aside cash for "one-off" rescues of major institutions, the man who runs the Treasury's $700 billion bailout fund said on Tuesday. Neel Kashkari, who will stay on for several more weeks as the administrator of the Troubled Asset Relief Program (TARP) said the program should stay focused on shoring up the financial sector. The Bush administration has requested that Congress release the second $350 billion in funding for the program to give President-elect Barack Obama a head start in dealing with financial system stress.

Speaking to students at Georgetown University's McDonough School of Business, Kashkari said his phone has been "ringing off the hook" from a wide range of companies, industries and municipalities seeking a piece of the aid money. "We believe the TARP should be focused on the financial system. It's designed for that, our programs are set up around that," Kashkari said. "And we think if there are contingencies for other industries that those are best dealt with in legislation specifically geared toward those." Congress can reject the TARP funding request and many lawmakers have said they want the next $350 billion to include aid to stem foreclosures and wider benefits for American consumers.

Obama's top economic adviser, Lawrence Summers, assured top lawmakers in a letter on Monday that the aid would get to smaller banks, businesses and municipalities and would help Americans buy cars or get college loans. Kashkari said the next phase of TARP funding could include a second round of capital investments into banks, which could be achieved by a matching program, under which the federal government matches private capital raisings. But TARP needs to be able to deal with "systemically important" institutions, he said. The Treasury devoted about $85 billion of the first phase of TARP to shore up American International Group and Citigroup. "It's impossible to predict what's going to happen. We hope that the actions that we've taken are sufficient, but we are also going to have enough dry powder on the side to deal with any one-offs that arise," Kashkari said.

Thus far, the Treasury has disbursed $265.3 billion of the first $350 billion to financial institutions and struggling Detroit automakers. In addition to the Citigroup and AIG rescues, the Treasury has made capital investments in 257 banks totaling $189 billion, but thousands more institutions have applied for government cash through their federal regulators. Kashkari said it will take time for the capital investments to have the desired effect of making credit more available. The Treasury still has around $60 billion to invest in banks under TARP, before moving to the second $350 billion. "There is a huge demand for the program. The number of applications under review at the regulators is in the thousands, representing every state in the country, and hundreds more have already been pre-approved by Treasury," Kashkari said.

Even before word came on Tuesday that Citigroup might split into pieces to shore up its finances, an unpleasant message was moving through Congress and President-elect Barack Obama’s transition team: the banks need more taxpayer money. In all likelihood, a lot more money. Mr. Obama seems to know it; a week before his swearing-in, he is lobbying Congress to release the other half of the financial industry bailout fund. Democratic leaders in Congress seem to know it, too; they are urging their rank and file to act quickly to release the rescue money. And Ben S. Bernanke, the chairman of the Federal Reserve, certainly knows it.

On Tuesday, Mr. Bernanke publicly made the case that one of the most unpopular and most scorned programs in Washington — the $700 billion bailout program — needs to pour hundreds of billions more into the very banks and financial institutions that already received federal money and caused much of the credit crisis in the first place. The most glaring example that the banking system needs even more help is Citigroup. Though it already has received $45 billion from the Treasury, it is in such dire straits that it is breaking itself into parts. Like many banks, Citi is finding that its finances keep deteriorating as the economy continues to weaken.

Even some of the bailout program’s harshest critics acknowledge that things most likely would be even worse without it, and that the bailout had accomplished its most important goal, which was to prevent a complete collapse of the financial system. Since last September, no major banks have failed and the credit markets have thawed somewhat. But analysts said the problems are still acute, if less apparent on the surface. Banks have received $200 billion in fresh capital from the Treasury since last fall and have borrowed hundreds of billions of dollars more from the Fed. But in the meantime, the economy fell into a severe downturn last fall that is likely to continue until at least this summer.

Industry analysts estimate rising unemployment and business failures will lead to another $500 billion to $750 billion of losses in coming months. That could bring total losses from the credit crisis to $1.5 trillion to $1.8 trillion, twice as high as earlier estimates. Citigroup is not alone. JPMorgan Chase, Bank of America, Wells Fargo and most other big banks all expect enormous losses as millions of consumers default on their mortgages, credit cards and automobile loans. Other losses are expected on loans made to commercial real estate developers, small businesses and for highly leveraged corporate buyout deals.

Mr. Bernanke bluntly warned on Tuesday that the government would probably have to infuse more money into financial institutions in the months ahead. “More capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets,” Mr. Bernanke said in a speech to the London School of Economics. Mr. Bernanke, tacitly acknowledging the unpopularity of the bailout program, said the public was “understandably concerned” about pouring hundreds of billions of taxpayer dollars into financial companies — especially when other industries were getting the cold shoulder.

But, he insisted, there was no escape. “This disparate treatment, unappealing as it is, appears unavoidable,” Mr. Bernanke said. “Our economic system is critically dependent on the free flow of credit.” Mr. Obama and his economic team have assured Congress that they would use a sizable chunk of the new money from the Troubled Asset Relief Program to help distressed homeowners refinance mortgages and escape foreclosure. That would be a big shift from the Bush administration, which refused to use TARP for reducing foreclosures.

Lawrence H. Summers, Mr. Obama’s choice to head the White House National Economic Council, assured Democratic lawmakers in writing on Monday that the administration would use some of the money to help reduce foreclosures. But Mr. Bernanke appears to be warning Mr. Obama and Congressional Democrats that most of the remaining $350 billion — and possibly more — has to go to shoring up banks if they are to resume lending at normal levels. During the first three quarters of 2008, banks were able to raise enough capital to offset more than their hundreds of billions in losses by tapping the giant government bailout fund as well as some early private investors.

But that was only a stopgap. “The capital raises finally caught up with the losses,” said Michael Zeltkevic, a partner at Oliver Wyman, a consulting firm specializing in the finance industry. “It doesn’t make the situation better, but at least we caught up.” The new tidal wave of losses stems from the worsening economy and rising unemployment, and analysts say it will take several quarters before it peaks. Regulators require banks to keep a healthy cushion of capital. But this time around, the banks are struggling to plug their deepening holes. Private investors are scarce. For all but a small group of healthy banks, bankers and analysts say, the government may be the only investor left.

“Most banks are going to be in a defensive posture,” said Christopher Whalen, a managing partner with Institutional Risk Analytics. “You are probably not going to see the industry expand its overall balance sheet until 2010 or 2011.” Mr. Obama’s economic team is planning a broad overhaul of the program to impose more accountability and more restrictions on executives at companies that receive government money. Policy makers are also looking at reviving the original idea of TARP — have Treasury buy up unsalable mortgage-backed securities from financial entities.

Henry M. Paulson Jr., the Treasury secretary, had dropped the idea, concluding it would be more efficient to inject capital directly into banks by buying preferred shares. Mr. Bernanke revived the idea, along with several other approaches, in his speech in London. So did Donald L. Kohn, vice chairman of the Federal Reserve, in a hearing on Tuesday before the House Financial Services Committee. He suggested the Treasury could buy the unwanted securities directly, or set up special banks to buy them.

Some analysts, even those who agree that the government needs to prop up the banking system with more taxpayer money, were skeptical about TARP. Adam S. Posen, deputy director of the Peterson Institute for International Economics, said that the Bush administration had been right to inject capital into banks but wrong in not pushing banks hard enough to fix their problems or accounting. “The problem isn’t that we’ve wasted money,” Mr. Posen said. “The problem is that we’ve put too few conditions on the banks.”

Big investment banks ripped up more than $30,000bn worth of credit derivatives last year, or almost half the record total outstanding at the start of 2008, as they aggressively pursued efforts to tidy up the industry. Regulators raised the already-strong pressure for reform of the derivatives industry following the rescue of Bear Stearns and the collapse of Lehman Brothers, prompting banks to step up moves to terminate old and superseded contracts.

TriOptima, the company that organises so-called compression cycles where trades are torn up, said the industry managed to cancel $30,200bn of credit derivatives in spite of the strain put on bank back offices after the failure of Lehman and a number of other institutions in the final quarter of last year. Industry representatives point out that its ability to cope with the collapse of Lehman and still remain open for trading even as bond markets seized up was testament to the improvements made to market infrastructure and to the strength of provisions against counterparty risk.

However, that has not stopped widespread demands for improvements, not least through the creation of a central clearing house, to help improve the transparency of trading activity and risk in the market. "By reducing exposures through regular compression cycles, the dealers were able to continue providing effective risk mitigation tools while responding to regulatory concerns about counterparty exposure and operational challenges," said Brian Meese, chief executive of TriOptima, which is part-owned by Icap, the interdealer broker.

The over-the-counter derivatives industry has been under pressure to clean up its act for the past couple of years, but regulators became even more concerned once they realised how complicated would be the failure of a big derivatives counterparty after the Bear Stearns rescue. Banks' efforts to clean up credit default swaps began with modernising and speeding up the processing and confirmation of trades, then moved last year into pruning the large volumes of older, outstanding trades. The $30,000bn excised from the market last year was three times the $10,000bn taken out in 2007.

The first half of last year saw the first decline in outstanding notional volumes, which shrank from $62,300bn to $54,600bn by June 30 2008, according to the International Swaps and Derivatives Association, the main lobby group for the industry. TriOptima said that the size and number of compression cycles slowed in the second half as resources were diverted towards dealing with the collapse of Lehman Brothers and other large financial institution defaults.

The reintroduction last week in the US Senate of a bill aimed at amending the bankruptcy code to allow the modification of mortgage contracts - and its backing by Citigroup - has sent tremors through the market for mortgage-backed securities. The ABX index, which tracks the value of securities linked to subprime mortgages, fell sharply, with the value of triple A rated securities backed by subprime mortgages falling up to 6.5 points. Much of this decline is attributed to the increased chances of so-called bankruptcy cramdown bills passing. Politicians such as Senator Dick Durbin have been proposing such changes for years, but now measures aimed at reducing foreclosures have more support, not least from President-elect Barack Obama.

"The bill's passage would be a clear negative for mortgage-backed securities and asset-backed securities holders," said analysts at Barclays Capital. "We fear a massive sell-off that would worsen valuations, threatening further balance sheet write-downs [for financial institutions]."Even if a consumer files for bankruptcy, judges cannot currently change, for example, the size of the outstanding mortgage to allow a new, lower repayment plan. If such powers are given it has long been argued that the potential for changes in contracts would make investors less willing to finance the mortgage sector, or at least require a higher premium to do so.

These powers would likely affect mainly risky mortgages such as subprime. These are different to the mortgages backed by government mortgage agencies Fannie Mae and Freddie Mac. Securities backed by these have rallied after the Federal Reserve last week began a $500bn buying plan. Chris Flanagan, analyst at JPMorgan, said the bankruptcy cramdown may reduce foreclosures and stabilise house prices but that higher costs would be passed onto consumers. Increased bankruptcy filings could also increase losses on securities backed by credit cards and other consumer loans, he said.

"We are not surprised to see the market react negatively," Mr Flanagan went on. "While lenders have long maintained that [the lack of cramdown] was needed to keep mortgage rates low, that notion ultimately proved to be a farce. To say that now is not a good time to change the bankruptcy code merely echoes the sentiment of the last 30 years, and ignores the facts that [this part] of the mortgage market is shut down anyway."

Last week, financial industry groups denounced Citigroup's support of the changes. The bank was bailed out by the US government last year after the value of its mortgage-backed assets collapsed, further increasing the hole in its capital base. The Securities Industry and Financial Markets Association and the American Securitisation Forum said the bankruptcy proposals "would have serious and negative consequences, increasing risk and uncertainty in an already challenging mortgage market and raising mortgage rates for future homeowners at a time when the availability of consumer credit is already severely constrained".

Chrysler is in talks to sell key assets to Renault-Nissan and auto supplier Magna as it rushes to restructure after taking $4 billion in U.S. government loans, according to people with knowledge of the discussions. The string of potential deals would deepen ties between Chrysler LLC and two of its key current partners but could also mark the end of the struggling No. 3 U.S. automaker as an independent venture. Renault-Nissan and Chrysler, which is owned by Cerberus Capital Management, had some contact about a sale of all or parts of the U.S. automaker last year before the U.S. government stepped in to bail out Chrysler and General Motors Corp in December.

The present round of talks with Renault-Nissan gathered momentum in recent weeks and has included discussions about a deal to sell Chrysler's iconic Jeep brand, according to three people with knowledge of the talks. Renault-Nissan, an alliance headed by Carlos Ghosn, has been looking to clarify whether a deal to acquire assets from Chrysler would jeopardize the company's access to U.S. government funding, one of those familiar with the talks said. Representatives of Chrysler, Cerberus, Magna and Nissan had no comment. Renault, which owns a controlling 44 percent stake in Nissan, could not be immediately reached for comment.

Chrysler Chief Executive Bob Nardelli said this week that he was not preparing the struggling automaker for sale. Ghosn has repeatedly said he would not consider a deal that would involve spending cash in an uncertain market. Chrysler has also discussed selling its assembly plant in Belvidere, Illinois, to Canadian auto supplier Magna in exchange for long-term production contracts, according to the three people familiar with the automaker's talks. In a separate set of deals, Chrysler is also looking to sell the tooling and other assets related to its PT Cruiser model, the three said.

Sen. Bob Corker, a Tennessee Republican who has been one of the auto industry's most outspoken critics in Washington, said on Tuesday that Chrysler could be made more viable by merging with a larger automaker. "They probably would be better if they were attached to a larger platform," Corker said as he toured the Detroit auto show. Corker, whose home state includes the North American headquarters of Nissan and one of the Japanese automaker's assembly plants, met on Tuesday with representatives of U.S. automakers, including Chrysler. Chrysler was given $4 billion in U.S. government loans earlier this month and has said it plans to ask for another $3 billion in funding to head off a cash crisis.

Chrysler's U.S. sales dropped 30 percent last year and it burned through more than $9 billion in the last six months of the year to end 2008 with around $2 billion in cash. A fourth person familiar with the situation said Chrysler's position had worsened significantly since initial contacts about a potential sale last year and that Ghosn's opposition to taking on another brand had deepened in the interim. Chrysler and Nissan announced an alliance last April that paves the way for Chrysler to have a small car built by Nissan. In exchange, Chrysler would build a new full-sized pickup truck for the Japanese automaker using Nissan's plans in 2011.

Magna also has a long relationship with Chrysler. Magna Steyr, a unit of Magna International, makes minivans and other models for Chrysler in Austria. Magna had been one of the bidders for Chrysler when it was sold by former owner Daimler AG in 2007. In addition, former Chrysler Chief Operating Officer Wolfgang Bernhard has become an adviser to Magna. Chrysler's Belvidere plant was extensively retooled in 2005 and is considered one of the automaker's most flexible and valuable assembly plants. It makes the Dodge Caliber, Jeep Compass and Jeep Patriot models.

In a separate deal, Chrysler has been in talks with a pair of Chinese automakers, Chery Automobile and Guangzhou Automobile Industry Group Co, to sell them the PT Cruiser brand and tooling, according to the three sources. Chery, China's fourth-largest automaker, last month said it had broken off talks with Chrysler over plans to build a car under a Chrysler brand for sale in South America. Chrysler said last year that it would discontinue the convertible version of the PT Cruiser. It is widely expected to scrap all versions of the PT Cruiser, which are made in Toluca, Mexico, after sales of the 2009 models.

Chrysler has been seeking over $100 million for the tooling and rights to the PT Cruiser brand in a deal that would set one of the Chinese automakers up to make the model in China for that market, the three sources said. A spokesman for Guangzhou Auto said he was not aware of any Chrysler talks but did not rule out interest in overseas auto assets. Chery could not be immediately reached. Shares of Nissan closed up 3.5 percent at 325 yen after the news although they were off the day's high of 333 yen. Nissan's credit ratings were put on review for possible downgrade by Moody's, with the rating agency saying it was concerned Nissan's operating performance could be pressured by the worsening outlook for auto markets.

It's no coincidence President Bush has requested the second $350 billion of TARP funds at the same time Wall Street is grumbling about how Citigroup, and possibly Bank of America and others, may need additional capital. But before the government puts another dollar of taxpayer money into the banks, they must force these firms to "lift the kimono" and write-down their bad assets, says Joshua Rosner, managing director of Graham Fisher and one of the first analysts to warn of a pending crisis in the mortgage.

"Because the assets continue to get worse, the capital [banks] are given just gets hoarded," Rosner says. "They need to hold capital in order to meet regulatory capital requirements instead of using it to make loans that seek productive economic returns." Treasury could act as a clearinghouse for bad debt and hold open market auctions to determine the "true price" of those assets. Once those market prices are established, we can determine which banks are still viable and which aren't, Rosner says. "Then the FDIC can come in in a traditional way [to seize troubled banks] or the government could then use TARP money to institutions free of bad assets."

Forcing banks to take write-downs before the government injects capital is how Sweden successfully resolved its banking crisis in the 1990s.But even if the "Swedish solution" were adapted, Rosner says the structured finance market remains broken, which is preventing all this government money from making its way into the economy in a meaningful way. He compares it to opening a water spigot without having the pipes to take the water where it needs to go. If this market isn't fixed, the risk of a deflationary spiral intensifies because the "velocity of money" has slowed to a standstill.

The Government is considering creating a "bad bank" to house the billions of pounds of toxic assets owned by Britain's major lenders. The Treasury is understood to have asked the investment bank Credit Suisse to draw up a detailed plan for the logistics of creating a bad bank, in a bid to restore confidence in the sector and to kick-start lending to consumers and businesses. A bad bank has been floated as a potential measure to help solve the financial crisis by analysts but it has risen up the political agenda in recent weeks as banks' balance sheets look increasingly dire. Lloyds TSB, HBOS, Royal Bank of Scotland (RBS) and HSBC will report results for 2008 in the next few weeks. The City expects that combined they will announce write-offs which wipe out the Government's £37bn cash injection in October.

According to banking sources, the Government is considering two models for a bad bank. One would be to buy toxic assets from lenders and transfer them into a bad bank. The problem with this option is that if banks have not written down the value of their assets aggressively enough, they may have to suddenly crystalise new losses when assets are sold to the Government. The alternative is for problematic investments to be left on banks' own balance sheets but to be ring-fenced and given a Government guarantee. This plan would be harder to implement but would avoid the need for another round of write-downs by some lenders. Northern Rock could be used to house the bad bank, analysts believe. The Government is increasingly interested in creating a bad bank, in the hope that it would stave off the need for another massive capital injection of taxpayers' money into banks.

However, analysts and banking insiders believe the bad bank will not be enough to restore investors' faith in the sector and that Government will still need to agree another multi-billion pound recapitalisation scheme to bolster banks' capital. JP Morgan analyst Carla Antunes da Silva yesterday estimated a bad bank may have to take about £260bn of toxic assets from UK banks but said the advantage of setting one up would be that new capital injections would be "less risky". Professor Peter Spencer of the University of York said: "These so-called toxic assets are nothing of the sort: they are only toxic in as much as they are poisoning the life-blood of the financial system. If the Government bought toxic assets from the banks that would leave banks room for new lending. Only after that can we know which banks can survive on their own two feet and which will need further capital injections."

Shares in Barclays fell sharply on speculation that the bank, which did not take Government money in the October bailout, would need to fall back on public help, potentially by both using the bad bank and by taking part in a future recapitalisation by the Government. Meanwhile, RBS sold its $2.4bn (£1.65bn) stake in Bank of China. The sale, the first move by new chief executive Stephen Hester to shrink RBS's balance sheet, was completed at a smaller discount to the market than had been expected. However, RBS's shares fell on fears that it faces $3.5bn of losses on loans to bankrupt US company Lyondell Chemical. The Government will today unveil a package of measures to boost lending to small and medium-sized businesses, which is set to include a guarantee on £10bn of lending to businesses.

HSBC Holdings is likely to halve its dividend and may need to raise up to $30 billion in a rights issue, according to leading analysts, sending shares in Europe's biggest bank to a seven-year low. Morgan Stanley slashed its earnings forecasts for HSBC for this year and next, and said its relative capital position is not as strong as in the past. "Our detailed study of HSBC's capital and asset quality position reinforces our belief that it will have to halve the dividend and raise major capital in 2009," Morgan Stanley analysts Anil Agarwal and Michael Helsby said in a note.

By 5:35 a.m. EST HSBC's London-listed shares were down 8.4 percent at 586 pence, after hitting 581.5p, their lowest level since September 2001. Its Hong Kong shares closed down 4.1 percent at HK$70. The DJ Stoxx Europe bank sector was down 5 percent as the capital worries, a profit warning from Deutsche Bank and big job cuts highlighted the problems facing the industry. HSBC has easily outperformed rivals in the past year as unlike most big banks it has not had to raise capital, due to its historically strong capital and liquidity. But it is facing increasing scrutiny over any potential need to raise funds as the economy worsens.

"Historically, HSBC has carried about 120 basis points of surplus capital at the group level - this has now all but gone at a time when we think it better for the buffer to have increased," Agarwal said in the note. "We believe HSBC is highly likely to cut the dividend in 2009, and in our bear case we now pencil in a 20 billion pounds ($29.2 billion) rights issue." HSBC paid out about $10.1 billion in dividends in 2007. HSBC's tier 1 capital was 8.9 percent at the end of September, above the European average. Its core tier 1 ratio stood at 7.5 percent at the end of June.

HSBC declined to comment on the research note, but in the past it has said it is comfortable with its capital position and its high cash generation, strong liquidity and funding keeps its capital well topped up. Some analysts expect it to only raise capital if it takes advantage of problems elsewhere and makes an acquisition. Morgan Stanley estimated HSBC had injected about $11 billion of equity into its subsidiaries last year, and said its core capital ratio included about $15 billion of available-for-sale reserve, which most European and Asian banks are not allowed. Others analysts have also said HSBC needs to raise capital to restore its advantage over rivals.

Citigroup, Santander, Royal Bank of Scotland, Barclays and many others have taken state rescue funds or raised cash privately to rebuild balance sheets. Agarwal cut his HSBC 2009 earnings per share forecast by 39 percent to 55 cents, down from an estimated 90 cents for 2008, and cut its 2010 forecast by a third to 50 cents. HSBC faces structural and cyclical headwinds from lower interest rates, higher bad debts and unfavorable foreign exchange moves, he said, predicting weaker revenue in the United States, Britain and Asia as a global recession takes hold. "If HSBC cut its dividend by half its dividend yield will fall to 5 percent from 10 percent and given the bank's huge exposure to the UK and U.S. market, 5 percent yield is not attractive anymore," said Steven Leung, director with UOB Kay Hian in Hong Kong. HSBC's earnings are not expected to recover until 2011 at the earliest, Morgan Stanley said.

The Government has slashed the cost and more than doubled the scale of government loan guarantees designed to encourage banks to lend to more businesses. Lord Mandelson, the Business Secretary, has announced plans to guarantee as much as £20bn of bank loans to small and medium-sized companies to ensure credit keeps flowing. Companies with sales of up to £500m will be able to qualify for the support. "UK companies are the lifeblood of the economy, and it is crucial that government acts to provide real help," said Lord Mandelson.

The plan is designed to allow banks to lend to businesses that would normally be turned away because of the deterioration in trading conditions and the decline in value of their assets, such commercial premises and directors' homes, which are often taken as security. Another new scheme, called the Enterprise Finance Guarantee, will cost up to £1bn in guarantees, with the banks holding £300m. The move comes as the Government's £500bn bail-out fails to unlock the frozen lending markets and get credit moving around the economy again.

The Federation of Small Businesses has called on the banks to make the guaranteed loans available immediately. Mark Prisk, the shadow small business minister, said: "Small businesses have waited a long time to hear the details. Whilst welcoming any proposals, the question is: 'When will the money reach companies?" Figures from the British Bankers' Association released last night showed that outstanding term loans increased by £153m in November to £45bn - half the average monthly rise for the first nine months of the year.

Russia accused the US last night of "orchestrating" Europe's gas crisis as gas deliveries to the EU were halted hours after they resumed, amid venomous exchanges of accusations between Moscow and Kiev. Gazprom, Russia's gas company, said its pumping stations began sending gas through Ukraine early yesterday, following a monitoring deal signed in Brussels on Monday. But hours later, Gazprom said Ukraine was blocking the flow of gas - adding that the US was to blame.

The EU said "little or no gas" flowed yesterday to countries in central and southern Europe suffering acute energy shortages. Gazprom said Ukraine had stopped shipments and prevented Russian observers from entering its gas stations. Ukraine said Russia had "provocatively" sent the gas the wrong way, and compared Moscow's actions to the Nazi siege of Leningrad. "We believed yesterday that the door for Russian gas was open but again it's been blocked by the Ukrainians," said Gazprom's deputy chairman, Alexander Medvedev. "It looks like ... they are dancing to the music which is being orchestrated not in Kiev but outside the country."

The state department dismissed the accusation. Medvedev later explained he was referring to Ukraine's strategic partnership deal with the US, which was signed in Washington last month by the US secretary of state, Condoleezza Rice. That pact enhances co-operation on defence, energy and trade, including the delivery of gas. The agreement will also see the US set up a diplomatic mission in the Crimean regional capital of Simferopol - a move likely to infuriate the Kremlin. The ethnic Russian region has been at the centre of claims that Moscow is trying to fuel separatist sentiments in order to undermine Ukraine's pro-western leadership.

Last night Medvedev said it was "pretty strange" the charter envisaged co-operation between Ukraine and the US on gas since Ukraine "didn't produce gas". "Ukraine has discredited itself. It's like a madman with a razorblade in its hands," he said. But Ukraine blamed Russia. Its state energy firm, Naftogaz, said there had not been enough co-ordination over the routes chosen for the gas and the volumes shipped. "This seriously violates the established practice of reliable functioning of the gas transit system," Naftogaz said.

Ukrainian officials said Gazprom had "deliberately" sent the gas by a route that would have meant switching off gas to Ukrainian consumers in the east of the country. Instead of supplying gas via the traditional route, through Ukraine's Belgorod and Rostov region, it had been sent on a bypass route which would paralyse supplies to the towns of Donetsk and Luhansk. "This is just provocation against Ukraine," said Bohdan Sokolovsky, Ukraine's commissioner for energy security.

Ukraine's president, Viktor Yushchenko, went further. His office compared Russia's actions to those of the Nazis during the wartime siege of Leningrad. Andrei Kislinksy, deputy head of Ukraine's presidential secretariat, said the gas war "increasingly resembles the blockade of Leningrad after the failure of the blitzkrieg" and added that its primary purpose seemed to be about making Yushchenko step down from office.

Germany’s economy could have contracted by as much as 2 per cent in the final quarter of last year, the country’s statistical office warned on Wednesday. Preliminary estimates, indicating that gross domestic product fell by between 1.5 per cent and 2 per cent compared with the previous three months, highlight the scale of the downturn in Europe’s largest economy. They are likely to fuel fears that Germany’s recession will the worst since the second world war, and drag down economies across the continent and adding to pressure policymakers to beef-up emergency economic rescue packages.

“We expect real GDP to contract by around 2.5 per cent this year,” said Alexander Koch at Unicredit in Munich. Statistics office officials warned in Frankfurt that estimating the fourth quarter figure was more difficult than normal because of the exceptional economic circumstances. But a sharp fall had been widely expected after the collapse in industrial production that has already been reported. The first official figures for fourth quarter GDP will be published on February 13. First estimates for German GDP for 2008 as a whole proved significantly weaker than expected. The 1 per cent, work-day adjusted increase followed a 2.6 per cent rise in 2008.

Growth was driven by investment and by government spending. Although exports grew by almost 4 per cent, imports grew faster, and overall foreign trade made no contribution to growth. More Germans had jobs in 2008, however, than in any year since German reunification in 1990. The public sector deficit shrunk to just 0.1 per cent of GDP in 2008 – but is expected this year to exceed the maximum of 3 per cent allowed under European Union fiscal rules as a result of the government’s fiscal stimulus package.

Germany will change its constitution to ban excessive public borrowing and impose strict new rules to ensure the extra debt created by its latest fiscal stimulus package is paid off as soon as possible, Angela Merkel, the chancellor, said on Tuesday. Underlining Berlin’s concern about the erosion of fiscal discipline in Europe, the chancellor said she was determined to balance public-sector budgets in the medium term. “We will have to borrow more,” she said. “But we must also be credible vis-à-vis future generations when we say we intend to repay this debt.” Ms Merkel’s comments were made as she unveiled a two-year €49.25bn ($65.5bn, £44bn) package of growth measures, including public investments and tax cuts.

These will raise the amount Berlin is spending to fight the economic crisis this year to 1.5 per cent of gross domestic product. Under the constitutional amendment outlined on Tuesday it will be illegal for any government to raise the state’s public deficit above 0.5 per cent of GDP “in normal economic times”. For 2008, such a rule would have capped borrowings at €12bn. The finance ministry is also to set up a “redemption fund”, with binding rules that commit the government to repaying the cost of the stimulus package by a set time. The fund would be similar to one created in 1995 to manage the repayment of the €171bn in extra borrowings linked to German unification – a goal finally met last year. This measure could force future governments to tap windfall tax revenues to repay debt once economic growth reached a given threshold, Ms Merkel said.

Alternatively, it could earmark Bundesbank profits for debt repayment. Ms Merkel is keen for Germany to remain a fiscal role model despite adopting the biggest stimulus since the federal republic was created 60 years ago – and the largest in Europe since the start of the financial crisis. Senior members of the chancellor’s coalition gave warning on Tuesday that Berlin was facing a borrowing spiral that would take decades to reverse. “I am expecting a federal deficit of €60bn this year,” Steffen Kampeter, public finance expert for Ms Merkel’s Christian Democratic Union in parliament, said. This would be €20bn above the postwar record. “The government is giving the impression that it is again opening the deficit floodgates.”

With its fiscal package, the government is raising long-term public investment by €17.3bn, two-thirds of which will go into education. The plan also includes almost €20bn in tax and social security contribution cuts. Berlin will set up a €100bn “Germany fund”, managed by the KfW public sector development bank, to provide companies with loans and credit guarantees as banks tighten lending conditions. The chancellor described “the biggest economic stimulus in the history of the federal republic” as “a rounded package”. However, many economists saw a loose collection of half-hearted measures designed to appease warring factions in the government.

Thomas Mayer, chief economist at Deutsche Bank, said: “As political considerations played a significant part in the design [of the package], its effectiveness in our view is likely to be less than it could have been.” Holger Schmieding, an economist at Bank of America, wrote in a note that Tuesday’s package was “a very mixed batch”. The package could be diluted as it passes through parliament. Coalition MPs were frustrated with the speed with which they had to pass last October’s bank rescue measures. Under less pressure, they may want to make a bigger mark on the final product.

The German government may end up with an indirect stake in Deutsche Bank through a renegotiation of the bank's takeover of Postbank, according to media reports that coincide with news that Deutsche lost €4.8 billion in the fourth quarter. Deutsche Bank, Germany's biggest commercial bank, has renegotiated its planned takeover of retail bank Postbankin the wake of the financial crisis in a deal that will effectively give the German government a three percent stake in the fiercely private bank, German newspapers are reporting. The new agreement currently being worked out falls far short of the partial nationalization of rival Commerzbankannounced last week, under which the government is taking a direct stake of 25 percent and will have the power to block all major corporate decisions.

But it's significant given that Deutsche Bank Chief Executive Josef Ackermann has insisted his bank can and will weather the financial crisis without help from the state. He even said he would be ashamed to take money from the government. "The financial crisis is leading to a reorganization of the sector that would have been unfeasible until recently," said Hans-Peter Burghof, the head professor of the banking and finance department at Germany's Hohenheim University. One analyst said: "The state would in effect have a stake in one of the most private of Germany's private banks." Deutsche Bank last September reached an agreement to purchase a 29.75 percent stake in Postbank for €57.25 per share in the first quarter of 2009 -- a total of €2.79 billion ($3.7 billion) -- in the first step towards a takeover. The price was regarded as high even at the time. "Deutsche Bank evidently expected that the financial crisis would soon be over," said Burghof. But it was wrong. Shortly after the deal was signed, US investment bank Lehman Brothers went bust and financial stocks plummeted. "The purchase turned out to be a big mistake.

Today Deutsche Bank could buy Postbank for a fraction of that cost," said Burghof. At midday on Wednesday, Postbank shares were trading at just over €14. That's why the deal is now being renegotiated. Business dailies Handelsblatt and Financial Times Deutschland reported on Wednesday that the new version was almost finished and envisages Deutsche Bank paying for part of the stake with its own shares. It's a solution that reduces Deutsche's capital outlay at a time when capital is generally in short supply. In return, German postal and logistics company Deutsche Post will get a stake of around 10 percent in Deutsche Bank. Deutsche Post is 31 percent-owned by the German government via state development bank KfW, so the government will effectively end up owning three percent of Deutsche Bank. The back-door entry by the government may suit Ackermann. His categoric refusal of state assistance in the financial crisis meant the mighty manager had to watch on as competitors around the world got shored up with public money.

Ackermann risked suffering a classic competitive disadvantage, said one analyst. With the new deal Ackermann could kill several birds with one stone. "It would be a face-saving compromise," said banking expert Wolfgang Gerke. The advantages would outweigh the embarrassment, he added. The first tranche of Postbank shares will remain expensive for Deutsche Bank because there won't be a discount, the newspapers reported. But the Postbank shares won't change hands until the summer, which means that Deutsche Bank can wait until then to make a takeover offer for outstanding Postbank shares. A Deutsche spokesman declined to comment on what he called "market speculation". "We're sticking to our investment in the first quarter," he said. Deutsche Post too didn't want to comment: "We have an agreement with Deutsche Bank and we stand by that," a spokesman said. But he confirmed that Deutsche Post's supervisory board would discuss the deal at a meeting on Wednesday.

Deutsche Post has been trying to get rid of its Postbank unit for a long time, but had to increase its stake in the bank in recent months because of the financial crisis. When the original deal was agreed in September, Deutsche Post had a 50 percent stake in Postbank. But the bank had to sell €1 billion of its own stock in November because of the crisis. Deutsche Post was the only possible buyer, and its stake rose to around 63 percent as a result. Last week Postbank admitted that it fell deep into the red in 2008. Insiders speculate that it lost between €600 million and just under €1 billion. It's little wonder that banking experts such as Gerke think Ackermann should stop ruling out assistance from the government's financial sector stabilization fund.

No one knows what risks the Postbank takeover poses and how long the crisis will last. Deutsche Bank on Wednesday reported a €4.8 billion loss in the fourth quarter, according to provisional results. Ackermann said he was "very disappointed. The extremely difficult market environment has revealed several weaknesses in the bank," Ackermann said in a statement. The losses stemmed in part from trading in credit products, equity derivatives and stocks, the bank said. Earnings were also hit by writedowns and restructuring costs. Deutsche said it expects to post a net loss of €3.9 billion for the full year 2008. The final results will be presented on Feb. 5.

How much longer can Deutsche Bank continue to convince investors it doesn't need to raise new capital? The German giant has successfully maintained its high wire act since the start of the credit crisis despite being one of the most highly leveraged banks in the world. But Wednesday's warning of 4.8 billion euros lost in the fourth quarter is a major stumble. Everyone knew the quarter would be grim, given the extreme volatility after the collapse of Lehman Brothers and the subsequent shock to global economic activity. But the scale of the loss puts Deutsche Bank's capital adequacy firmly back on the agenda.

What makes Deutsche's warning most troubling is that the losses have arisen not from traditional problem areas such as leveraged lending and commercial property -- exposures now mercifully virtually eliminated -- but across the bank's proprietary trading activities. Deutsche Bank consistently cites the supposed lower risk of these activities to justify its high leverage relative to other major banks -- Deutsche Bank has a tangible equity to total assets ratio of 1.8% the second lowest in its peer group, according to Morgan Stanley research. True, Deutsche has promised to reduce leverage by scaling back on prop trading and shed 300 billion euros of assets over the quarter -- although this was partially offset by the rise in the value of derivative contracts as a result of increased volatility.

Slashing the dividend and paying for its stake in Germany's Postbank in shares rather than cash should also help Deutsche achieve its target of 30 times leverage by the end of the first quarter, down from 38 times in mid-2008. The bank expects to continue to hit a Tier 1 capital ratio target of 10%. But resisting pressure to raise capital is becoming an increasingly risky gamble. The shares have fallen by two thirds since September in line with the rest of the sector, suggesting the market is skeptical of Deutsche's claim to special status. That skepticism is justified. Deutsche has less exposure than rivals to consumer and corporate loans and thus to the sharp deterioration in the real economy.

But the ballooning stock of assets no longer marked to market -- including Level 3 assets and securities transferred from the trading book to the banking book -- has left the bank's balance sheet less transparent. If investors conclude a major capital injection is necessary, raising the prospect of substantial dilution, Deutsche may find itself having to act against the backdrop of a confidence-sapping downward spiral in the shares. Best not to wait until that moment arrives.

The German government's partial nationalization of Commerzbank reflects the severity of the financial crisis. Berlin wants to use Commerzbank to jump-start stalled bank lending to companies, but it's paying a high price to do so. It's a proud building with a height of 259 meters -- 300 meters including the antenna --making it the highest skyscraper in Germany and the third-highest in Europe. It was designed by Sir Norman Foster, the star architect. This building exudes the ambition of a company that wants to display its wealth and its power, and that wants to play in the big league. But things have gone wrong for Commerzbank. Its proud tower is about to become the tallest branch of the federal government since last week's announcement that it will be partially nationalized.

Berlin is taking a €10 billion stake in Commerzbank, an investment that will it direct influence in the business operations and structure of a major German commercial bank. The government will also become the guarantor of the planned merger between Commerzbank and Dresdner Bank, acquired by Commerzbank in a deal arranged last year. The financial crisis has reached a new level. Until now, the government had administered its capital injections as cautiously and selflessly as it could in a bid to revive the ailing banking sector. Now the maxim has changed. The Commerzbank deal has turned the government into the most important shareholder in Germany's second-largest private sector bank. Berlin will have two representatives on the supervisory board and its 25 percent stake gives it the power to block every major decision Commerzbank's management board takes in the future. "I can only congratulate Herr Steinbrück,"

Chancellor Angela Merkel said in a speech to business leaders last Friday, referring to Finance Minister Peer Steinbrück. "At last the banking package is working." That's a pretty euphoric interpretation of a rather sobering development. After all, Commerzbank has had to be rescued twice in the space of just a few months. That might explain why the deal got a muted response in the financial markets. Commerzbank's stock plummeted at the end of last week and rival banks grumbled about "competitive disadvantages in the credit business," while many people saw the government's stake purchase as a disturbing sign that the financial crisis is getting worse.

The last time the state bought a stake in Commerzbank was 80 years ago, in the summer of 1931, at the height of the global economic crisis. At the time the government wanted to demonstrate that it remained capable of taking action, and it's no different today. The government wants to prove that its rescue package for the financial sector can effortlessly master even the biggest challenges. The message is that if the banks don't provide the economy with enough credit, the government will step in and find alternative ways to get credit flowing. The government's stake purchase shows that nothing is impossible in this crisis now. Only half a year ago it had seemed inconceivable that a major German bank would be partially nationalized. And only recently, Steinbrück had declared that the government would under no circumstances exercise "strategic influence on the banking sector."

When Commerzbank first asked for government assistance last November, the government's financial market stabilization fund, known for short as Soffin, provided €8 billion without taking a stake in the bank. But just before Christmas it became clear that that injection would not suffice. Dresdner Bank in particular had just finished a disastrous fourth quarter. It has so many bad securities on its books that government experts described the bank as "toxically charged." At the end of June the bank still had structured securities worth at least €31 billion. The subsequent writedowns narrowed its capital base to such an extent that the merger with Commerzbank was suddenly in danger. The government wanted to prevent the collapse of the merger at all costs because that would have caused fresh panic in an already nervous financial sector.

In addition, the Allianz insurance group, which still owns Dresdner, would have been hit by billions of euros in losses. Last Wednesday Commerzbank Chief Executive Martin Blessing met Finance Ministry deputy Jörg Asmussen, Economy Ministry deputy Walther Otremba and other members of Soffin's steering committee at the Berlin Finance Ministry for a final round of talks on the deal. The president of Germany's financial sector watchdog, Jochen Sanio, and Allianz Chief Executive Michael Diekmann were also present. At 3:30 p.m. they agreed to provide Commerzbank with a fresh cash injection of €10 billion. According to Blessing, that money will make Commerzbank "even safer", but it's not an especially attractive deal for taxpayers. In return for a direct capital investment of €1.8 billion and a silent deposit totaling €16.4 billion, the state is merely getting a stake of 25 percent plus one share, even though Commerzbank's current market value is less than €3.6 billion. The government doesn't just see the stake as a way to build trust in the new bank. It's also intended as a precautionary measure. "We want to protect our and the taxpayers' money," one finance ministry official said.

The government was worried that private speculators could buy up Commerzbank and plunder the state's investment of €18 billion -- with the government's blocking minority, that's no longer possible. The government is convinced that it has invested its money well. The bank is committed to repaying the silent deposits as soon as it's able to. But that's likely to take some time. In its best year, 2007, Commerzbank earned a net profit of €1.9 billion. The government wants to sell its 25 percent stake when Commerzbank has recovered and its share price has risen significantly from last Friday's level of €5. High-ranking government officials estimate it will take at least three years for the stock to recover. Until then, the government wants Commerzbank to do something that Germany's banks are singularly failing at -- lend money.

Commerzbank has recently been paying out more loans to small and medium-sized businesses than any other bank. "In the last few months it has been aggressively offering favorable terms to woo customers that had been turned away by other banks," said Brun-Hagen Hennerkes, head of the Foundation for Family-owned Businesses. That's what the government wanted. Blessing recently even launched a special credit program for medium-sized firms. But if the recession begins to bite, the companies' credit ratings will deteriorate and the bank will have to set more capital aside for its loans to meet banking sector regulations. That's why Commerzbank needs more cash from Berlin. "We now have enough of a cushion for the future," said Blessing.

It's certain that the merger between Commerzbank and Dresdner would have collapsed without the fresh money. Allianz as the only solvent partner would have had to inject a lot more cash to prevent Dresdner Bank from going under, and may have even have got into trouble itself. But worst of all, Finance Minister Steinbrück would have had to abandon his dream of having two internationally competitive German banks. It's true that the new Commerzbank including Dresdner Bank has turned out to be a colossus with feet of clay. But its sheer size has inspired the government's hope that things will get better at some point. The partial nationalization isn't just aimed at helping Commerzbank The government above all wants to revive its financial sector rescue plan in the face of growing criticism. The problem is that the package with its €400 billion in state guarantees and additional €80 billion in equity assistance has so far failed to restore the banks' trust in each other -- the banks are still refusing to lend each other meaningful sums of money. As a result, many experts are calling for a fundamental revamp of the government's financial sector rescue package launched late last year. Some are even demanding that banks be forced to participate. But Steinbrück insists that participation remain voluntary.

Even before it received the latest infusion of government cash, Commerzbank had become the government's darling by successfully offering Germany's first state-guaranteed bond with a volume of €5 billion. It can now lend this money to companies. Steinbrück now hopes that other banks will follow Commerzbank's example and take refuge under Berlin's umbrella. There's no shortage of possible takers, such as regional bank HSH Nordbank. The Hamburg-based bank has already obtained €30 billion in liquidity guarantees from Soffin. HSH head Dirk Jens Nonnenmacher has little room for maneuver. Insiders expect the bank to report a loss of around €2 billion for last year. The former math professor wants to restructure his balance sheet by ridding the bank of risky assets totaling up to €80 billion. And even if manages to do so it's not clear that the bank will be able to survive. Last Thursday, HSH executives were again summoned to Soffin to discuss a bond issue and the bank's revamped business model. An equity injection of the type Commerzbank has received wasn't discussed, although insiders say it may happen any day now.

But time is running out, and the bank's owners are getting nervous. The savings banks of the northern state of Schleswig-Holstein that own a stake in HSH are neither willing nor able to pump another euro into the bank. And the governments of Schleswig-Holstein and Hamburg that also own stakes are arguing about who's responsible for the debts. Nonnenmacher's counterparts in other regional banks aren't much better placed. Analysts say Landesbank Baden-Württemberg may also need a capital injection from Soffin. Two teams of experts are currently scrutinizing the bank and will submit their reports on its financial health at the end of the month.

The biggest unknown is whether market leader Deutsche Bank will need assistance, despite assurances to the contrary from its chief executive, Josef Ackermann. Deutsche Bank had a grim fourth quarter. But Ackermann wants at all costs to avoid asking Soffin for help. His strategists appear to be toying with the idea of getting additional funds if necessary from private investors or foreign state funds. The bank has declined to comment on that. The German government's purchase of a stake in Commerzbank could now exacerbate Deutsche Bank's problems. How should it respond if its rival uses its new-found strength to gain a competitive edge? If Deutsche Bank doesn't succeed in getting fresh money, the bank will have no alternative but to ask Soffin for help. "Then Ackermannn would probably have to quit," said one Frankfurt banker.

German economic growth slumped last year as the global financial crisis hurt exports and damped spending, pushing the euro area’s largest economy into a recession in the second half. Gross domestic product grew 1.3 percent in 2008 after expanding 2.5 percent in 2007, the Federal Statistics Office said in Frankfurt today. Economists expected growth to slow to 1.4 percent, according to the median of 31 estimates in a Bloomberg News survey. Germany had a budget deficit of 0.1 percent of GDP.

Companies are scaling back production and cutting jobs as global economic expansion slows and demand for German exports wanes. Bundesbank President Axel Weber last week indicated the economy may contract more this year than the bank’s 0.8 percent forecast. A decline of more than 0.9 percent would be Germany’s worst performance since records began after World War II. “There is just no sign of the economic decline bottoming out,” said Kenneth Broux, an economist at Lloyds TSB Group Plc. in London, who expects the German economy to shrink 2.1 percent this year. “The first and second quarter will be awful. If we are very lucky, we may see a slight stabilization in the third or the fourth quarter.”

The economy may have contracted as much as 2 percent in the fourth quarter of last year from the third, the statistics office said. That would be the biggest quarterly contraction since 1987. Company investment in plant and machinery rose 5.3 percent in 2008, the office said, and construction spending increased 2.7 percent. Exports gained 3.9 percent and imports rose 5.2 percent. Consumer spending, the biggest component of GDP, stagnated. Chancellor Angela Merkel’s coalition yesterday agreed to spend an extra 50 billion euros ($66 billion) this year and next, abandoning a drive to eliminate the budget deficit to focus on battling the recession instead.

The European Central Bank has cut its key interest rate by a total of 175 basis points to 2.5 percent since early October as Europe’s economic slump deepened. Investors bet it will lower borrowing costs again tomorrow by at least 50 points, Eonia forward contracts indicate, even as some policy makers signal they’d rather wait. ECB President Jean-Claude Trichet said last month there’s a limit to how far the bank can cut rates and refused to give any signal for January. Executive Board member Juergen Stark said on Dec. 10 that the scope for further moves is “very limited.”

“The ECB should lower interest rates by half a percentage point this week and one more time thereafter,” said Holger Schmieding, chief European economist at Bank of America Corp. in London. “They have to, should and will do it.” German business confidence dropped to the lowest in more than a quarter of a century in December and unemployment rose for the first time in almost three years. Plant and machinery orders plunged 30 percent in November from a year earlier, the VDMA machine makers association said today.

China’s economy overtook Germany’s in 2007 to become the world’s third largest, underscoring the nation’s increasing economic and political clout. Gross domestic product expanded 13 percent from a year earlier, more than a previous estimate of 11.9 percent, to 25.731 trillion yuan ($3.38 trillion), the statistics bureau said on its Web site today. That topped Germany’s 2.424 trillion euros ($3.32 trillion), using average exchange rates for 2007.

China’s economy is 70 times bigger than when leader Deng Xiaoping ditched hard-line Communist policies in favor of free- market reforms in 1978. After overtaking the U.K. and France in 2005, China became the third nation to complete a spacewalk, hosted the Olympic Games and surpassed Japan as the biggest buyer of U.S. Treasuries. “This number is just one more piece of evidence that China is one of the most important players on the global stage,” said Huang Yiping, chief Asia economist at Citigroup Inc. in Hong Kong. The figure was released as China faces the weakest economic expansion since 1990 after exports collapsed because of the global recession.

German economic growth slumped last year, according to numbers released by the Federal Statistics Office in Frankfurt today. Gross domestic product grew 1.3 percent, down from 2.5 percent in 2007. China’s economy may now be as much as 15 percent larger than Germany’s, Louis Kuijs, a senior economist at the World Bank in Beijing, estimated. He confirmed the calculation that it overtook Germany in 2007. The U.S. economy is the world’s biggest, followed by Japan’s. “If China continues to grow at its average rate in the past 20 years and if the U.S. does the same, it will overtake the U.S. in 20 years,” said Tim Condon, head of Asia research at ING Groep NV in Singapore. “There’s no doubt that that will happen -- it’s just a matter of time.”

The nation’s enlarged role in the global financial system was highlighted when it cut rates at the same time as the U.S. Federal Reserve and five other central banks in October to counter the deepening credit crisis. In contrast, Japan stood on the sidelines. China is the biggest contributor to global growth and underpins demand for metals, grains and the exports of its Asian neighbors. It also has a big stake in the U.S. economy, holding $652.9 billion of U.S. Treasuries, according to Treasury Department data.

Since introducing free-market policies, China has lifted 300 million citizens out of poverty, according to the United Nations. Before the latest revisions, the nation’s per-capita gross national income was 132nd in the world at $2,360, behind Angola at 125th and Azerbaijan at 126th and ahead of Tonga at 133rd, according to the World Bank. “The size of China’s GDP tells us something about how quickly it is getting richer compared to other countries but in terms of per-capita GDP it is still less than 10 percent as rich as Germany is,” said Kuijs. The nation hosted the Olympic Games in August last year, sent men into space in September and aims to land a man on the moon by 2020.

“We have overcome challenges in the past 30 years, from the breakup of the Soviet Union to facing down global sanctions, from the Asian financial crisis to the current global crisis,” President Hu Jintao said last month. “Our international profile is rising and we will play an increasingly constructive role.” Global interests spanning African oilfields and South American mines are encouraging China to add to its military might. The nation sent ships to fight pirates off the coast of Somalia last month and will “seriously consider” building aircraft carriers, the Ministry of National Defense said.

“China’s importance goes beyond even the ranking as number three because it’s one of the only resilient economies in the world today,” said Citigroup’s Huang. Still, growth is sagging. The economy grew 9 percent in the third quarter of 2008, the least in five years. The fourth-quarter expansion, due to be announced next week, was 6.8 percent, the weakest since 2001, according to the median estimate of 12 economists surveyed by Bloomberg News. The nation’s 4 trillion yuan stimulus package, announced in November, may help to limit the severity of the slowdown.

Growth in car ownership, a potent symbol of China's economic rise in recent years, is crumbling -- taking with it one ray of sunshine for auto makers. The onus is now on Beijing to prop up the world's second-largest auto market, even if a U.S.-style bailout isn't yet needed. Along with hopes the government's fiscal stimulus package will underpin commercial-vehicle sales, the industry is lobbying for a cut in the 10% tax levied on car purchases.

Even that might not prove enough to stop the slide in sales growth. The trend is already worrisome. A 7.3% rise for 2008 doesn't look so bad, but it was the Chinese auto sector's worst growth rate for a decade. Sales have fallen for four of the last five months; December sales were down 11.6% from a year earlier. A swift restoration isn't likely. Faltering consumer confidence and falling property and equity prices have made potential car buyers less willing to flash their cash. A lower cost of borrowing in China won't help much; less than 10% of vehicle purchases are debt-financed.

So without any reduction of the car purchase tax, there will likely be no growth in auto sales this year, Daiwa Institute of Research estimates.That's bad for multinationals that have become increasingly reliant on China as a good-news story. Volkswagen, the Chinese market leader, generates 16% of its annual sales from China, making it the company's second-largest market. At least VW's sales are still growing in China -- hard-pressed General Motors has already seen passenger-vehicle sales fall in 2008 at its Chinese joint venture.

More auto makers will follow GM into a declining sales environment unless the Chinese government acts. Even to get near 2008's level of growth, Daiwa says the government will have to target any tax cut toward purchases of small-engine cars. More than 60% of China's car market is for vehicles with less than 1.6-liter engines. Whatever Beijing's decision, speed is of the essence. The signs are even those still willing to buy cars are delaying purchases until the tax situation becomes clearer, and car prices fall further.

It wasn't supposed to be this way. BNP Paribas thought it was bolstering its balance sheet and gaining regional heft in buying the Belgian assets of Fortis for €14.5 billion ($19.25 billion), less than half their book value, last October. With Fortis facing a bank run, the French were helping prevent the disintegration of the Belgian banking system. Instead, the French bank finds itself at the mercy of disgruntled shareholders and the Belgian courts that see BNPP as a party to a fire sale that trampled on shareholder rights and saw politicians interfere in the judicial process. The deal has a good chance of unraveling.

Minority shareholders may well vote down the transaction at court-ordered meetings to approve them next month. BNPP has limited scope for mollifying investors beforehand. The bank can't negotiate directly because the sale agreement, which expires end-February, is with the Belgian government, which is anyway keen to see the deal go through as it is already uncomfortably exposed to the financial sector, having rescued Dexia and KBC. The minority shareholders want more than a token concession such as retaining a 49% stake in Fortis's insurance unit. That would suit BNPP, saving it nearly €3 billion in cash. But investors want cash or alternatively for Fortis to be reconstituted as a Belgian bank and insurance business, which they argue would be worth more than the BNPP offer.

Judging the validity of that claim in the current economic environment is tricky, given the lack of visibility on future losses and earnings. But Fortis Banque Belgium is well capitalized, with a core Tier 1 capital ratio of around 12%, twice that of BNP Paribas and boosted by proceeds from the sale of Fortis's Dutch assets to the Dutch government. With deposits guaranteed by the state, which wasn't the case at the time of the BNPP deal, the bank's also liquid with a 1:1 loan-deposit ratio. The insurance arm is solid. So shareholders may be right to argue Fortis is worth nearer the 0.7 times book value the sector is trading on than the 0.43 times BNPP paid.

But there's next to no chance BNPP will sweeten its cash and share offer. A bad fourth quarter at its investment bank raised fresh questions about its skinny capital ratios compared with other European banks. Its share price is down 50% since October. Losing Fortis would be a missed opportunity but no worse. The government in Brussels should brace itself for the prospect of finding alternatives to BNPP. If the shareholder votes go badly, reviving Fortis and merging it with the sickly Dexia might amount to making the best of a bad job.

In an interview with SPIEGEL, the new head of the Federation of German Industries discusses developments in the country's economy as a result of the global downturn and the government's multibillion euro stimulus package , which he says can help "jump-start" the system.

SPIEGEL: Mr. Keitel, would you hazard an economic prognosis for 2009?Keitel: That would be reckless. The economy and the political world can only fly by visual flight rules at the moment ...

SPIEGEL: ... directly into the worst recession since World War II?Keitel: Yes, that seems to be the tendency, although I don't want to be overly pessimistic. This is the kind of crisis we have never seen before, one that affects every country in the world and every sector. A completely new dimension for everyone.

SPIEGEL: It has already struck the German automobile industry in full force. Is climate protection just another problem for the industry, or is it an opportunity?Keitel: In general, climate protection is a huge opportunity for the entire domestic industry, because our global leadership position in technology provides us with excellent export opportunities. Seen in that light ... we should not devote all of our energies in Germany to achieving the latest fine-tuned improvements, but should develop and sell mass-market products for the global market.

SPIEGEL: In light of the economic crisis, some politicians and business owners want to see the climate goals loosened, arguing that they are now no longer affordable.Keitel: You won't get me to agree with that. The political goals have already been formulated and we will reach them, but perhaps just somewhat more slowly.

SPIEGEL: What are your members' biggest problems at the moment? Declining orders? Sudden cancellations? Credit problems with the banks?Keitel: All of these effects are related. The scenarios for which business owners should prepare themselves today include initially theoretical declines of 20 percent in sales and five percentage points in profit margins. Such developments already pose an existential threat to many companies. This makes it all the more problematic that credit conditions have clearly deteriorated. Many types of loans simply no longer exist.

SPIEGEL: In other words, the often-cited credit crunch has already been around for a while.Keitel: We shouldn't complain about it. Instead, we should discuss the problems openly with the banks, so that we can find our way out of the dilemma together.

SPIEGEL: But the German government has already approved a €480 billion ($658 billion) rescue plan, although very few financial institutions have taken advantage of it so far…Keitel: … partly because the details of the conditions for these government bailouts may have to be changed.

SPIEGEL: Such as?Keitel: It is my impression that extending the terms of the government loans from three to five years could already help the banks. Besides, the funds should also be disbursed more quickly than they have been until now.

SPIEGEL: Is the rescue package working if it doesn't even prevent the credit crunch?Keitel: If you consider what politicians have achieved in such a short amount of time, I would say that the project is clearly the right thing to do.

SPIEGEL: How does one explain to taxpayers the idea that they are suddenly being asked to foot the bill for the bankers' greed and megalomania?Keitel: First, we must explain the differences between direct aid and guarantees to taxpayers. In this context, some politicians are behaving in a populist and irresponsible way.

SPIEGEL: All the same, €80 billion ($110 billion) in equity capital is available ...Keitel: ... which I don't want to downplay. But the banks are not getting all of this as assistance to the sector or out of sympathy, but to keep the financial system afloat. The banks must also live up to their responsibility. Ultimately, we are all talking about money that we don't have and that will have to be paid back at some point. Even if the government spent €100 billion, it could not save the community on its own. But it can provide the right stimuli to jump-start the system.

SPIEGEL: The German government hopes to revive the economy with another package of measures worth €50 billion ($69 billion). Is this the right approach?Keitel: The scope is okay. But we must be careful not to allow the debt burden to become so large that our children and children's children will still be paying for it. The government should commit itself to reducing the new loans by 2013. To achieve a lasting effect, we must remove the burden from those whose work creates our prosperity. For this reason, I expressly welcome the Christian Democratic Union's plan to deliberately remove the burden from our society's top performers in advance of a tax reform.

SPIEGEL: Are you talking about the highest-paid senior executives of industrial corporations?Keitel: I am talking about the millions of skilled workers and qualified employees, who the government deprives of much of their increased earnings in the form of taxes and fees. After the parliamentary elections, the acute relief must be followed by significant reforms. Even the knowledge that this will happen would be helpful now.

SPIEGEL: Are you saying that no more acute measures are needed?Keitel: No. The planned investment programs are clearly the right approach. However, cities and towns must also show some flexibility. I doubt that the municipalities are spending all that money earmarked for new roads, schools and sewage systems quickly enough.

SPIEGEL: There are also doubts as to whether the domestic construction industry can even handle the sudden sharp rise in demand.Keitel: Many small to mid-sized companies have only enough orders to keep them busy for two months. They would be extremely grateful for more investment. The companies will undoubtedly handle the additional orders ...

SPIEGEL: ... but primarily with Eastern European personnel.Keitel: After years of decline, the German construction industry cannot develop new capacities on the spur of the moment. But foreign workers will also spend their money here and will buy German products. And my third point is that we must help companies so that they can send as few people as possible into unemployment.

SPIEGEL: How can that be achieved?Keitel: By the government helping to pay for the retraining of people whose hours are now being cut back, for example. That would boost the labor market, while at the same time pushing urgently needed training programs.

SPIEGEL: Are you satisfied with what CDU Chancellor Angela Merkel and SPD Finance Minister Peer Steinbrück have done so far?Keitel: I am familiar with the criticism, but I also see how quickly the government has acted so far in this unprecedented situation. And I, as an engineer, have a certain amount of sympathy for the analytical care with which the problems were approached in Berlin. In my view, the emphasis is on politics, not parties. In this super-election year, the BDI will comment clearly on whether Berlin is on the right track.

SPIEGEL: Your organization has lost much of the public's attention in the recent past. Will that change under your leadership?Keitel: I have a different opinion in that regard. But not all debates have to be hammered out in public. The important thing is that we bundle the expertise collected within the BDI and continue to promote the interests of German industry, which creates real value.

SPIEGEL: In other words, the internal divisions within the federation have come to an end?Keitel: I know that there will always be differences of opinion in and beneath an umbrella organization like ours. But given the gravity of the situation, we cannot allow ourselves to get bogged down with the details. This sort of thing only helps cheap populists, who then tend to question our social market economy ...

SPIEGEL: ... the image of which has already suffered greatly, and not just since the current crisis began. Just think of the scandals surrounding VW, Siemens, Lidl and Telekom.Keitel: The same examples have been cited repeatedly for some time now. Fortunately, upstanding business owners and managers are in the overwhelming majority. Anyone who is in a position of leadership represents a part of the local elite -- and bears personal responsibility for our social market economy. What Catholic social teaching and the Protestant church have had to offer more recently in this regard is surprisingly relevant ...

SPIEGEL: ... and astonishingly critical of the economy, especially when you read books like the one by Munich Archbishop Reinhard Marx.Keitel: I see eye-to-eye with the major denominations on many of the issues relating to the decline of values and trust. Yes, there is indeed a rapid decline in credibility. For a long time my own industry, construction, was certainly not among the most transparent, but it too has since undergone an astonishing change. Morality is not an abstract concept for Sunday sermons, but something incredibly pragmatic.

SPIEGEL: At Hochtief, you traveled to many developing countries. As a result, you know how corruption works.Keitel: When you go on vacation, you also know where there is malaria, and you prepare for it. It's a similar thing with corruption. When I was sent out as a young man, I had no idea and was lucky to have had the right compass. Nowadays young managers receive excellent preparation and can call their company's ethics hotline at home at all times. It can happen that they are ordered to fly home immediately. And you will find that some countries have not appeared in Hochtief's order books in 10 years.

SPIEGEL: You were never infected by the malaria of corruption?Keitel: No.

Former technology titan Nortel Networks Corp. is expected to file for bankruptcy protection as early as today, sources say, a move that will likely see what was once Canada's great corporate success story broken up and sold to foreign rivals. Nortel's board of directors was meeting last night to deal with a financial crisis, as the economic downturn translates into a sharp drop in orders from phone company clients. The telecom-hardware manufacturer failed to find buyers for a number of divisions that were put up for sale in September, and faces the prospect of paying $107-million (U.S.) of interest on its debts tomorrow.

“It is an iconic Canadian name and there will be a great national grieving over this,” said one person familiar with Nortel's plans. The company's already crushed shares plunged further in European trading Wednesday as investors absorbed the development, falling to as little as the equivalent of 35.41 cents Canadian on the Frankfurt Stock Exchange, before inching back to 37.66 cents, down 2.9 cents from Tuesday's close. According to sources working with Toronto-based Nortel and its creditors, the company plans to seek court approval for creditor protection as early as this morning in Toronto and an undisclosed U.S. location. Nortel executives had no comment yesterday on the company's plans.

Opting for creditor protection would mark an incredible fall from grace for a telecom manufacturer that is almost as old as the telephone. Nortel easily qualified as the country's largest company at the peak of the tech boom in 2000, with a $366-billion (Canadian) market capitalization and 95,000 employees. While still North America's largest telecom equipment maker, Nortel's shares were worth a total of just $192-million yesterday, and the company has 26,000 staff after a bruising series of layoffs over the past eight years. Nortel stock that soared to $1,231 at the peak of the tech bubble – reflecting a recent consolidation in shares – closed yesterday at 38.5 cents on the Toronto Stock Exchange.

Court protection from lenders, and the breakup that will likely follow, would mark the end of chief executive officer Mike Zafirovski's four-year attempt to turn Nortel around. Mr. Zafirovski was parachuted into the top job in 2005 after successful stints at General Electric and Motorola. But he was never able to right a company plagued by a series of accounting scandals – one of his predecessors faces fraud charges – and weakening demand for its products. While not bankrupt – the company has an estimated $1-billion in its coffers – Nortel is burning though cash at an impressive clip, and has $4.5-billion (U.S.) in long-term debt.

Major lenders include JPMorgan Chase, Citigroup and Royal Bank of Canada. Seeking court protection would give the company more latitude in selling or restructuring factories and research facilities. Air Canada, for example, went this route in 2003, continuing to fly while cutting jobs and reworking its debts. Duncan Stewart, an analyst at DSAM Consulting in Toronto, said: “The issue is not whether or not they can pay it. … It's the idea of: If you know you're eventually going to default anyway, why not do it now and keep the … interest payments you would have shelled out?”

Typically, companies do not file for bankruptcy protection until they have drained most of their cash. But the deepening global credit crunch had raised concerns that a troubled company such as Nortel would not be able to raise enough money to finance its operations during bankruptcy proceedings. The court filing will come as a shock to the company's bondholders, who had expected Nortel to pay its debts this week. Shareholders will likely see their holdings all but wiped out. As a consequence of filing for protection, Nortel can expect to lose significantly more business, potentially sending the company into a death spiral, analysts say.

The sophisticated equipment made by Nortel carries an expectation from customers – the major phone companies – that the manufacturer will be around to service networks. One of the reasons the auto makers gave last month for resisting calls for them to file for bankruptcy protection was that potential customers would not buy from a manufacturer they did not think would be around to service the vehicles. For the network equipment industry, that fear is justifiably magnified. When Nortel said in September that it would put its Metro Ethernet Networks division up for sale – it makes hardware that carries Internet traffic – revenue fell on fears of sustainability and service.

Now Nortel faces the prospect of selling additional divisions to pay down debts, all under the supervision of a judge. In addition to selling the Ethernet unit, divisions that could go on the auction block include the carrier networks unit, which sells gear to phone companies, and the enterprise division that sells telecom equipment to businesses. Potential buyers for these units are all foreign: Nokia Siemens Networks, Telefon AB LM Ericsson, Cisco Systems Inc. and China's Huawei Technologies Co. Ltd. Nortel's storied history in the telecommunications field dates back nearly as far as the telephone itself. The company was founded in 1895 as Northern Electric Manufacturing Company to begin selling telephone equipment to other companies as Canada built out its first telecom network.

Throughout the first half of the 20th century, the company's telecom gear business grew steadily, but Nortel also built telegraphic equipment used on the battlefields of the First World War as well as the first sound system in Canada for talking movies. In the 1950s, the company developed electromechanical switches, a technology that would allow direct phone calls between cities. Nortel was an early pioneer of satellite technologies in the 1960s and helped build Canada's first cellular telephone networks.

Nortel's fortunes exploded with the dawn of the Internet and the introduction of increasingly sophisticated modems and cellular technologies. At its peak, this one company accounted for nearly one-third of the total value of the TSX; the company was worth more than all six big banks combined. Now the company is being brought to its knees by the prospect of paying $107-million of interest due to its bondholders this week. However, that is not the only financial deadline facing Nortel. On Dec. 15, the company was given a 30-day waiver from Export Development Canada on the government agency's support for up to $750-million of credit. The deadline on that waiver is today.

State governments from Rhode Island to California have run up estimated pension-fund losses of $865.1 billion, forcing some to cut benefits for new hires. Assets for 109 state funds declined 37 percent to $1.46 trillion over the 14 months ended Dec. 16, according to the Center for Retirement Research at Boston College. The Standard & Poor’s 500 Index of stocks fell 41 percent in the period. “Not a whole lot of people get too excited about pension funds,” Philadelphia Mayor Michael Nutter said in an interview. “But if you have to pay those costs, they do grab your attention.”

After Philadelphia’s fund lost $650 million in the first nine months of last year, Nutter joined the mayors of Atlanta and Phoenix in writing a letter to Treasury Secretary Henry Paulson seeking financial help for U.S. cities. Their November letter cited investment deficits and rising pension costs. The $865 billion in losses, which exceed the $700 billion Troubled Asset Relief Program that Congress approved in October, comes as states face budget deficits totaling $42 billion. The Boston College center analyzed holdings reported on financial statements from 2006, when the 109 funds had about 20.4 million members. It didn’t specify which of the 218 U.S. state funds it studied.

To return to 2007 actuarial funding levels by 2010, the 109 funds would need annual returns of 52 percent on assets, the analysis found. Annual returns of 18 percent would achieve the goal by 2013, the center said. The projections are based on a 5.7 percent annual increase in liabilities and a $50 billion increase in assets from contributions above annual payouts. State funds have enough money on hand to pay benefits for the foreseeable future, said Alicia Munnell, the center's director. Even if markets recover, this will be a one-time loss that will have to be made up in the future by taxpayers, “We can’t make enough on investments to drive out of this hole if all you do is depend on investments,” said Mike Burnside, executive director of the Kentucky Retirement Systems in Frankfort. As of June 30, Kentucky's largest fund for state workers held about 52 percent of the assets needed to pay current and future benefits to its 117,000 members. The plan had an unfunded liability of $4.8 billion at that time, while the entire system's liabilities totaled about $16 billion.

“When we are experiencing a negative cash flow and we are having to eat capital to make payroll, we are accelerating the complications,” Burnside said. Increasing taxes to fill the pension gap has little support, said Frank Karpinski, executive director of the Employees’ Retirement System of Rhode Island in Providence. I don't think anybody wants to do that, likes to do that or would say it would be an easy sell anywhere, especially given the current economic situation. State and local governments contributed $64.5 billion to pension plans in fiscal 2005-06, according to data from the U.S. Census Bureau. That’s about 57 percent of the $113.2 billion spent on police and fire services. Attempts to reduce benefits also face opposition.

“I believe that our members will oppose such initiatives in collective bargaining or in state legislatures,” said John Adler, a director with the Capital Stewardship Program in New York for the Service Employees International Union, which represents public workers. The union’s 850,000 members were in retirement plans with more than $1.5 trillion in assets as of Jan. 1, 2008, Adler said. To cut pension costs, some states are creating two-tiered systems offering less to new hires. Kentucky lawmakers this year set the state’s first minimum retirement age, 57, for employees hired after Sept. 1, and required 30 years of service, up from 27, to receive full benefits. They capped cost-of-living adjustments, which had been tied to the Consumer Price Index, at 1.5 percent. The system had an unfunded liability of about $16 billion as of June 30, executive director Burnside said.

New York Governor David Paterson, trying to close a $15.4 billion budget gap over 15 months, wants to reduce new workers’ benefits and raise the retirement age to 62 from 55. New York’s pension system was over funded, with assets of $153.9 billion, as of March 30. Of the 109 state funds, 43 were funded at 79 percent or less of estimated current and future costs. Those below 80 percent “constitute the weakest cases,” said Ted Hampton, an analyst with Moody’s Investors Service Inc. in New York. The average level is 85 percent, according to an analysis prepared for a Moody’s report published in July 2008, Hampton said.

Company pension funds have also lost assets in the stock- market decline. The value of so-called defined benefit plans fell to $1.1 trillion in October from $1.3 trillion at September’s end, according to Mercer LLC, a New York-based pension consulting unit of Marsh & McLennan Cos. Last month, after Pfizer Inc., International Business Machines Corp., United Parcel Service Inc. and dozens of other companies said losses could force them to make unexpectedly large contributions, Congress voted to delay provisions of the Pension Protection Act of 2006. The law would have penalized employers that didn’t cover at least 94 percent of their liabilities this year.

For state plans, which weren’t covered by that mandate, the funding issue is complicated by 12 percent growth in membership since 2002, with 23.1 million now participating, according to census data. Excluding Social Security, public employers’ pension costs are three times the retirement costs of their private counterparts, according to a June 2008 report by the Washington- based Employee Benefit Research Institute. Some state retirement systems have seen losses in derivatives as well as stocks. Public pension funds bought more than $500 million in so-called equity tranches of collateralized debt obligations, according to public records compiled by Bloomberg in 2007. CDOs are packages of securities that are backed by bonds, mortgages and other loans. Their equity tranches are considered their riskiest portions.

The Missouri State Employees’ Retirement System invested $25 million in half the equity portion of the BlackRock Senior Income Series 2006 collateralized loan obligation, managed by New York-based BlackRock Inc. Moody’s last month cut ratings on parts of the debt, saying a drop in value of the underlying collateral may cause “an event of default.” Chris Rackers, the manager of investment policy and communication for the Missouri fund, didn’t return calls seeking comment. In Rhode Island, state and local governments were scheduled to make contributions equaling 25 percent of their payroll expenses to retirement plans in 2010, said Karpinski, the executive director. Barring a recovery, the contributions may increase to as much as 30 percent in 2011, he said. “That is kind of the elephant in the room,” he said. “Where are the funds going to come from to make these kinds of required contributions?”

For five years, San Francisco attorney Tilden Moschetti practiced family law, but in November, he shifted his legal attention to reflect the demand in the market: personal bankruptcy filings. "It's a good market to get into," said Moschetti, who's advertising his practice online by updating a blog that follows bankruptcy news. "Considering where things are right now." As the economic downturn cuts jobs in many professions, the consumer bankruptcy attorney has thrived: Membership in the National Association of Consumer Bankruptcy Attorneys jumped by one-third in 2008, to an estimated 3,200 practicing lawyers.

The job description has also shifted. Bankruptcy attorneys, nearly put out of business by a 2005 law that made it more difficult for consumers to file, are dedicating more hours to hand holding devastated clients, compared with previous recessions. "It used to be that we'd get someone into bankruptcy so they could save their house," said Patrick McMahon, a San Francisco attorney for 25 years, who added that the foreclosure crisis has dashed most clients' hopes of salvaging their home. "But now, I spend a lot of my time trying to convince people to let their houses go - that it's not worth what they owe on it. They say, 'But we've got a bond with our house,' and I have to say, 'So what. Just let ... the house ... go.' " The glut of clients is a welcome turn of events for bankruptcy lawyers, if an unfortunate one for their clients, said Ike Shulman, a San Jose attorney and co-founder of the National Association of Consumer Bankruptcy Attorneys.

In San Francisco, filings at the U.S. Bankruptcy Court jumped to 20,067 in 2008 from 12,025 in 2007, and bankruptcies filed in California are up nearly 50 percent from last year, according to a study by the Consumer Bankruptcy Project at Harvard. More than 1.3 million people in the United States are expected to file in 2009. Shulman said his brethren sat at the brink of extinction in 2005, when Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act, intended to discourage a new generation of college graduates who were filing for bankruptcy to get out from under mounting student loans and overwhelming credit card debt. The number of filings, which had steadily averaged 1.5 million per year, dropped to 600,000 in 2006, the year after the act passed, leaving attorneys scrambling for clients.

"Many of us thought the real intent in 2005 was the credit card companies to drive the bankruptcy attorneys out of business," Shulman said. "Many of us got out at that time. There just wasn't enough business to go around. ... It's like they were making it so difficult for us to do our job, they wanted us to die off without killing us." Instead, just three years later and with a swift turn of economic fortunes, the attorneys have found new life and are retooling their trade to reflect the times in which clients are more likely to have lost everything, as opposed to reorganizing their debts.

Kevin Chern, a Chicago attorney who runs Totalbankruptcy.com, a site for attorneys and potential clients, also runs an administrative agency that oversees the paperwork and court filings so attorneys can spend more time with their clients. Chern said that since November, about 25 firms nationwide have inquired about his administrative service, all of them reporting being overwhelmed by the new workload. "When the attorney has too much on their plate, the client suffers most," Chern said. "You've got someone who's going through one of the most difficult times in their lives; you need to be there for your client and offer them the compassion they deserve." While the work of a consumer bankruptcy attorney may not be as glamorous as the criminal litigators portrayed on network television dramas, a report in June from the Government Accountability Office found that since the 2005 act went into effect, bankruptcy attorneys have increased their fees about 50 percent.

A bankruptcy attorney still gets most of the money up front. The cost of a typical Chapter 13 (reorganization) filing in Southern California has increased from about $2,000 to as much as $4,000 in 2008, according to the report. Attorneys polled in the Bay Area estimated the average cost was closer to $3,000. Fees for a Chapter 7 (liquidation) filing went from $712 to $1,078, according to the same report. The 2005 law also brought a fivefold increase in paperwork for attorneys, said Barbara Andelman, executive director of the National Association of Consumer Bankruptcy Attorneys. Aside from requiring their clients to take credit counseling classes and a debtor education course, bankruptcy attorneys are also required to personally certify to the court that the claims of their clients' financial woes are true. "Now our necks are on the line, too," Moschetti said.

It may be worth the risk, as the economy continues its slide. Moschetti said many of his potential clients are surprised to hear that they don't need an attorney to file for bankruptcy. But if they do, there are plenty to choose from. "As an attorney," Moschetti said, "the competition is out there."

Bankruptcy basicsKevin Chern, a consumer bankruptcy attorney who runs the Web site Totalbankruptcy.com, suggests those who are seeking an attorney consider three key questions:-- How long has the attorney been practicing bankruptcy law? Experience can help when navigating the complexities of filing.-- How much personal time will the attorney offer? Clients are more satisfied when an attorney takes their calls, as well as those of their creditors.-- Will the attorney set up installment payments or demand payment up front? Some clients can afford a lump sum, but others prefer the extra time.

Hedge-fund assets fell a record $350 billion, or 20%, last year as worsening market conditions prompted massive redemptions, liquidations and deleveraging, according to Eurekahedge. The worst three-month period, from September through November, accounted for 90% of drop, which took assets under management to $1.5 trillion by year's end, according a report by private-equity firm Eureka Private Equity. The declines in 2008 came as the financial crisis spurred investors to convert holdings to cash and some funds faced unexpected disruptions to their trading strategies, including temporary bans on selling stocks short.

With 39% of funds reporting their December assets, the group said assets fell $24 billion during the month, but so far more of the reporting funds have been in the black than those in the red. In fact, Eurekahedge's Hedge Fund Index has so far posted a 1% return for the month - its first positive return since May. Redemption pressure was also slowing, as more funds locked in investors and performance improved, the report said. Estimated net outflows for December were $28.2 billion, compared to $52.2 billion in November.

December is usually a positive month for hedge funds, and Eurekahedge said the trend likely wasn't bucked last year, despite the ongoing recession and negative repurcussions from the Bernard Madoff scandal. Asian funds benefited most from holding their net long position in anticipation of a year-end bear market rally, Eurekahedge said. European allocations were hurt by "aggressive rate-cutting by major central banks globally and the resulting spike in volatility," the company said.

A senior executive at the Swiss bank UBS was declared a fugitive on Tuesday, two months after being indicted by a federal judge in connection with a widening investigation of UBS’s offshore private banking services. The executive, Raoul Weil, 49, a Swiss citizen, oversaw UBS’s lucrative cross-border private banking operations from 2002 to 2007. His whereabouts are unknown. The development is a blow to UBS and is likely to complicate its position before federal prosecutors, who are conducting a criminal investigation into whether the bank deliberately allowed up to 20,000 wealthy American clients to hide $20 billion in secret offshore accounts, thereby evading $300 million a year in income taxes.

The investigation, which is peeling back layers of Swiss banking secrecy, has set the bank on a collision course with prosecutors and regulators, who contend that it sold tax-evasion services that are legal in Switzerland but not in the United States. UBS has said it stopped offering the services. It is closing client accounts, sending out checks and reporting the amounts to the I.R.S., which hopes to collect back taxes. Mr. Weil was declared a fugitive in a court paper signed by Judge James I. Cohn of Federal District Court in Fort Lauderdale, Fla.

Mr. Weil is the second person to be indicted in the investigation. In May, Bradley C. Birkenfeld, an American who was a senior private banker at UBS, was accused of helping a major UBS client evade taxes through undeclared offshore accounts; he later pleaded guilty. While Mr. Weil is the most senior UBS executive to be swept up in the investigation, the inquiry is focusing on other unnamed senior executives and bankers at the bank. Those people, according to the Weil indictment, “occupied positions of the highest level of management within the Swiss bank,” including senior positions in the legal, compliance, tax and risk departments.

As layoffs loom and pensions plummet, more people are unrolling their yoga mats and polishing their poses to find flexibility and sanity amid the financial chaos. Fitness experts say gym memberships are holding steady, or rising, and yoga classes are thriving. "The economy may have taken a downturn, but attendance in our yoga classes has grown," said Jess Gronholm, National Yoga Coordinator for the Crunch health club chain. "A yoga practice becomes a refuge from the negativity of an economic recession, and the studio becomes the sanctuary," said Gronholm, whose employer has over 100,000 gym members in five U.S. states.

Yoga, which originated in India, uses movement and postures to strengthen the body and breathing techniques and meditation to quiet the mind. Gronholm believes the 5,000-year-old practice is just the ticket in these belt-tightening, nail-biting times, when banks aren't lending, consumers aren't buying, and experts are calling the latest economic numbers terrifying. "At the very least members can come in and 'take a break' from whatever else may be going on in their lives. And at the very most, a practice can become a transformational experience that reenergizes and rejuvenates you," Gronholm said. A recent Roper poll, commissioned by Yoga Journal, found that 11 million Americans do yoga occasionally and 6 million perform it regularly.

These days, when an estimated 10.3 million Americans are jobless and countless more worry they will be, devotees are eager to cite the tranquility they have found by twisting their bodies into pretzel-like contortions. "People want to do something relaxing and physically active," Yoga instructor Adam David said after leading his class through a vigorous ashtanga-style session at a New York City studio. "My experience is that attendance in classes has gone significantly up in the past few months," said David, who turned to teaching yoga when his advertising jobs dried up in the recession of 2001. He conceded his private clientele have fallen off a bit, but "generally, my long-term private clients are financially well-off and eager to recommend me to their friends."

At Equinox Fitness, which operates a chain from coast to coast, the yoga business is also booming. "We've added yoga classes" said Nicole Moke, spokeswoman for the luxury fitness centers. "We add classes every January." And if the brunt of hard times should fall upon their well-heeled membership? "We've added a lot of meditation classes. Our members seem to be very excited about that," she added. California-based YogaWorks, which operates yoga studios on the East and West coasts, agrees that business is thriving. "In our experience attendance is up year over year," Marketing Director Terri Seiden said. "We expect to see this trend continue. In difficult times practicing yogis are more reluctant than ever to give-up their practice," she said from her office in Santa Monica, California.

Seiden said YogaWorks opened a new studio in January and has plans for more. "To that end we are hiring more teachers and studio staff," she said. So is yoga a recession-proof shelter from the storms of economic turmoil? "We don't say yoga is recession-proof but rather recession-resilient," Seiden said. "Yoga is one way that people can take care of multiple needs - it is a complete workout for your mind and body, a form of stress relief, entertainment and there is a sense of community as well." Om, Anyone?

hmm....sorry for being somewhat dense this fine ;) morning butquote>>"To go from deflation to inflation, you need an economic recovery"<<<does not stand up to much if any criticism - weimar germany, why go so far - Zimbabwe ?

Illargi, it is perfectly possible to have asset price deflation (and financial/economic malaise) at the same time as commodity price inflation (thanks to rampant credit extension and $$ printing/bailouts/liquidity injection and dollar depreciation)

1970's style stagflation, anyone?

Eric Janzen over at Itulip.com covers this well.http://www.itulip.com/forums/showthread.php?p=66592#post66592There is a huge distinction between asset prices in the FIRE economy and commodities, goods, services, and wages prices in the Production/Consumption economy.

Anons: I believe that Stoneleigh has always predicted future commodities inflation but just not anytime soon due to the scope and extent of demand destruction. Look no further than oil. The same can happen to gold too. If the market continues down south for several more thousand points, you will continue to see fund redemptions causing these funds to sell off their only remaining assets worth anything *think gold* which will crush the price (much like in Oct).

It's all a guessing game in the end as to the speed and extent because so much of this is underpinned by psychology. But the highly educated guess based upon and constrained by all known facts points to commodities deflation in the near-term.

FWIW a co-worker just returned from a trip to Hong Kong to visit family. He took a trip over to the mainland and was shocked by what he saw... pick pockets and petty crime everywhere. Not only are lots of people losing work, millions have lost what little savings they had in the stock market..... Welcome to capitalism.

From what I have read, in Weimar Germany employment was high until the height of the hyperinflation. People would buy anything they could get in order not to hold currency, so demand for goods was very high. It was a self-reinforcing cycle. From the outside it actually sounded good. American papers ran articles about the German economic miracle.

There are different ways to have hyperinflation, but I don't see how we can get ourselves into a Weimar model any time soon. We have too much personal debt and have lost a lot of the means of production.

"your statement that economic recovery is needed for inflation does not seem to hold true in a LOT of cases."

That is not my statement. I said, that's why I said "look", that economic recovery is required to go "from deflation to inflation."

And that's not even my line, it's how Evans-Pritchard interprets Bernanke's speech: "Ben Bernanke, chairman of the US Federal Reserve, has begun to sketch an "exit strategy" for the first time after embarking on the most radical monetary experiment in US history, insisting that huge infusions of money will fuel inflation once recovery starts"

There's no such things as asset price deflation or consumer price inflation. They are bogus terms. You either have inflation, or you don't. I have written a lot about that. See for instance The Grief Cycle.

Here's is what I wrote on May 11 '08.

"The inflation vs deflation discussion never seems to end. So here's yet another attempt at solving the errors that are constantly being injected. Trillions of dollars are gone through house price declines, imploding securities and dissolving derivatives, with much more to come (make that go). and we are supposed to enter an inflationary period? That is not possible, folks.

Inflation, when used as a term to describe rising prices in a particular segment of the economy, inevitably becomes a hollow term. These days, we can constantly read things like "food inflation" or "food price inflation". But there is no such thing. How do we know that? Well, there are several ways to figure this one out.

First, if you can call rising prices in one part of an economy "inflation", where does that stop? If for example food prices stay equal except for vegetables, do we have "vegetable inflation"? Perhaps the most obvious way to put this is to ridicule it. If prices for everything else remain the same, or even fall, but cookies get more expensive for some reason, are we seriously going to talk about "cookie inflation"? If not, there's no such thing as "food inflation" either.

Second, say we were to talk about inflation if for instance food prices go up, and food prices only. It's by no means impossible that prices for other items go down simultaneously. Using the terms this way, we would need to accept inflation and deflation happening at the same time. And that is ridiculous; the terms would have no meaning.

All this to say that rising prices by themselves cannot indicate inflation. Instead, it must be the other way around. You must have inflation first, defined as an increase in money supply and/or credit supply, and rising prices must come after. And it needs to be rising prices across the board, not just in one part of the economy.

In any other definition, the term "inflation" becomes nonsensical. A bad grain harvest turns into "grain inflation", peak oil leads to "oil inflation". And a strike in the cookie factory leads to cookie inflation. Yeah right. Let's stop doing that, why don't we?"

Bernanke is proposing to increase the complexity of the shell game.His version calls for "bad banks" created to "purchase assets from financial institutions in exchange for cash and equity".

Jon Moulton, founder of Alchemy Partners, told MPs on the committee that the banks had become "too damn complicated" and impossible to regulate or manage. He called for "narrow banks" to get back to the absolute basic activities of the sector.

JalIn a new model, the financial service provider ceases to be a middleman, or credit intermediary, and becomes a pure service provider. The fact is that in the Internet age there is no need for credit intermediaries, whether private banks or central banks.

We Spaniards are starting to get fed up with Ambrose Evans-Pritchard, and the Barclays' Telegraph, London, calling us PIGS all the time. Jeff Randall another of the hot shots who writes there went to Marbella, was charged 75 pounds for a pizza -they saw them coming, it is 20 euros at most- and says the euro is sunk and that all is well in Britain. Spain makes trains and sells them to the USA, what do they make? They aren't happy if they don't insult other countries, to hide the decadence of its own. Although it is true that we adore pigs and bulls and that's why we sacrifice them in religious ceremonies in the town squares, I don't think that's what they mean.

And there we get back to confidence. Banks don’t lend, and don’t trust each other, because they know they all have huge losses hiding in their vaults and their immediate futures.

I would say that even that is a symptom to the real problem, the underlying cause of all of this is that there are no more people to lend to, Americans have hit a debt ceiling that they simply cannot go past. While folks talk about sub-prime they never ask themselves a basic question and that is why did we lend all that money to sub-prime borrowers? The answer to that is because we had to, we had to because there were no more qualified borrowers and we had to continue the over-consmption economy.

And even underlying that is the real cause of all of this mess, and that is putting first-world labor costs in direct competition with third-world labor costs. In the end we went about $25 trillion dollars in debt past our collective ability to pay it back, sooner - and it does look to be sooner - or later that $25 tillion will come off the top of GDP going forward.

Unless of course all our employers decide to give us all big ole fat raises of around 15-20% so we can pay off our debts and still be able to consume. And how likely is that? None, Zilch, Nada, and unfortunately outside of that nothing nothing nothing and I mean nothing will work.

But is sure is funny seeing all these rich people still trying to figure out a way to continue to lend us what they won't pay us in income so that we can continue to over-consume like madmen and drive up the prices of their assets...

I watched Niall Ferguson present The Ascent of Money yesterday on public television. (Not bad, still, too much of the gee-wiz “who could have expected” element in it.) I think the most recent value of all derivative contracts was mentioned as $680 trillion on that show. Today’s rattle has the news $30 trillion of credit derivatives cancelled: “TriOptima, the company that organises so-called compression cycles where trades are torn up, said the industry managed to cancel $30,200bn of credit derivatives in spite of the strain put on bank back offices after the failure of Lehman and a number of other institutions in the final quarter of last year.”

Total Derivatives contracts outsize even the vast Bond markets. The failure of just a few percent of d. contracts has been mentioned as a sort of Sword of Damocles over us all here--guaranteeing further deflation and collapse. It took Warren Buffet, who coined the phrase “weapons of financial mass destruction”, many years to detangle the counter party risks involved in just one portfolio of derivative contracts purchased by Berkshire Hathaway. TriOptima’s new fangled “compression cycles” seem very efficient.

“TriOptima is an international financial technology company that is solving some of the most challenging post-trade processing problems in the OTC derivatives market. Focused on reducing costs and eliminating risks for its subscribers, TriOptima offers a range of services including the triReduce service in interest rate, credit and energy derivatives; credit event management services; and triResolve for collateral portfolio reconciliation. Headquartered in Stockholm, Sweden where development and production originate, TriOptima stays close to its subscribers with offices in London (TriOptima UK Limited), New York (TriOptima North America LLC) and Singapore (TriOptima Asia Pacific Pte Limited). TriOptima is a privately-owned company. Minority shareholders include ICAP plc, and Allen&Overy.” - http://www.trioptima.net/about

Only 96% more derivative trades to go! TriOptima would be a freakin' growth stock if it wasn't privately held.

The reality is that the prices of everything will adjust to the amount of money available to purchase them and the amount of money available to purchase things is going down dramatically.

The only way to inflate is by bringing wage and salary income up by 20 or so percent.

We will go through a depression who's first phase will be deflationary and who's second, much longer phase will be hyper-inflationary because the currency will crash. Already we can see that there will be no funding for the stimulus as there simply is no real physical money available to finance it and there will be serious competition for any and all available cash all around the world.

Once we find that we don't have the funding then we will simply monetize the debt and that will be followed by people dumping treasuries all over the world which will trigger a hyper-inflationary episode tnhat will ripple across the world in very bad ways...

http://citizensbriefingbook.change.gov/ Share your ideas on any issue facing the new administration, then rate or comment on other ideas. The best rated ideas will rise to the top -- and be gathered into a Citizen's Briefing Book to be delivered to President Obama after he is sworn in.

Ilargi has mentioned before that posting any article is not an implicit assent of that article, whether he specifically comments on it or not. He provides his opinion when and where he does so, but otherwise he has said that he wants people to take in all the salient viewpoints and do some of their own reasoning.

“During the final months of 2008, as the financial markets imploded, talk on trading desks turned to food and water stockpiles, generators, guns, and high-speed inflatable boats. “The system really was about six hours from failing,” says Gene Lange, a manager at a midtown hedge fund, referring to the week in September when Lehman went bust and AIG had to be bailed out. “When you think about how close we were to the precipice, I don’t think it necessarily makes a guy crazy to prepare for the potential worst-case scenario.”” The New Paranoia: Hedge-Funders Are Bullish on Gold, Guns, and Inflatable Lifeboats

No problem, CS. A lot of Ilargi's points (and Stoneleigh's) are scattered in the daily comment sections rather than in the posts, and it can be hard to catch everything (I certainly don't!). I like to think that us TAEers who are longer in the tooth can help out with some quick answers now and then.

The Telegraph crew, Ambrose first, these days talk about how bad the rest of the world is doing, and is pretty quiet about their own country. Germany, Spain, China, the boys have many favorite whipping dogs.

And so, Countryslicker, no, I don't have to agree with the opinions vented in articles in order to post them. I want people to make up their own minds, that's way more valuable than me doing it for them. Even if many people would prefer the latter. Still, I think my opinions shine through quite brightly.

Never thought I'd be able to discuss yoga on this blog, but you guys did post the article, so let me be the first to recommend this activity. I've been practicing for two years and the differences in my outlook and physical appearance are amazing! (Even completed teacher training last weekend...). I know you two are enthusiastic about the other exercise thing, but give yoga a try if you can. It's a lot more challenging than you think.

If you want a livestock guardian and a good friend, look at the Beauceron breed. Big enough to herd cattle, dissuade people, protective but not aggressive, good with children, very preoccupied with keeping its group together during walks (funny to see that), good family member, trainable. Best dogs we have ever had.

As I have mentioned I own a yoga studio. It is the closest thing I have encountered to a panacea. It combines excercise, both cardio and strenghth training, with meditation and pranayama or controlled breath. All combinations of movement with focused intent and breath can be considered yoga. I come from an ashtanga background which focuses on the flow rather that the perfect fulfillment of the posture and can attest that no matter how poor your conditioning that you can do yoga and that it will make your life better. (the non-evangelist in me must admit this applies to all exercise)

I've been practicing Hatha Yoga on a daily basis for the last five years. Not only does it get one in shape, but it's wonderful for the the spirit as well. I had a great teacher for four years. If a beginner, do find a good teacher. The breath, meditation and body alignment are very important.

It sure is funny how changing prices are confused with inflation, disinflation and deflation. The different KPIs are just a simplified way of measuring it. The idea is to use non-elastic commodies that do not change over time (so that they are comparable over time). Inflation is the relation between the money supply and goods supply. Simple as that.

“America needs better leadership; not these clueless jokers – Bernanke and Paulson. America is blowing up a bubble in public finance; it needs someone who understands how the public finance system works. America needs Bernie Madoff. Reports tell us that Madoff has not been arrested. He is at home, apparently watching the news on TV and waiting to hear from the gendarmes. Why not take advantage of his free time? Why not ask him to do some community service?”The Great American Ponzi Scheme By Bill Bonner

Jan 14th: Some of it was realized on increasing the mortage and used to buy cars/consuming as the house value increased on paper. I bet Illargi has numbers on that also!

Also in many countries the debt follows the person. Those who are forced to sell their home these days may not be able to repay the bank - and is left with a mortage and no home. They will not be contributing to the "growth" in many years to come...

P90X is hard, especially plyometrics (jump training). If you stick with it it works like nothing else though. At first I felt completely flattened, but now I can do almost everything, and generally as many reps as the instructors. I still can't do one-arm push-ups and a few other things though, so when they do that I just do regular ones.

When I started I'd never done a push-up in my life before, so being able to do several sets of 30 in a routine now is a big step up. Finally being able to do the Ab Ripper X routine is my crowning achievement I think. I thought having kids had finished my abs for good, but I rediscovered them after much hard work.

I worked up to much heavier weights than I was using initially, but I did it gradually as I was building muscle. The yoga and stretch routines are really important to avoid injury when doing a programme as intense as P90X. Trying to keep your neck muscles relaxed is a good idea as well, otherwise you might end up with tension headaches. It's hard to do that at first, but it comes with time.

I still don't look like the instructors, even after a year, but then some of them are insanely fit dancers, trainers, circus aerialists, ex-marines etc rather than middle aged ordinary people like me. The lead instructor, Tony Horton, was 45 in the videos (50 now and still just as fit), so there's great hope for older people too :)

If I own a house worth a trillion dollars and some twerp says, "okay my friend it is now of zero value." What effect does that have if I do not have it on the market. What I would like to know is what weight to put on these 'losses' ilargi speaks of. What proportion of those losses has some movement and what just sits there dull as some bloggers.

“EL PASO - Mexico is one of two countries that "bear consideration for a rapid and sudden collapse," according to a report by the U.S. Joint Forces Command on worldwide security threats.

The command's "Joint Operating Environment (JOE 2008)" report, which contains projections of global threats and potential next wars, puts Pakistan on the same level as Mexico.” http://www.elpasotimes.com/newupdated/ci_11444354

“The Mexican possibility may seem less likely, but the government, its politicians, police, and judicial infrastructure are all under sustained assault and pressure by criminal gangs and drug cartels. How that internal conflict turns out over the next several years will have a major impact on the stability of the Mexican state. Any descent by the Mexico into chaos would demand an American response based on the serious implications for homeland security alone.”http://www.globalsecurity.org/military/library/report/2008/joe2008_jfcom.pdfThe Joint Operating Environment(JOE) Distribution Statement A: Approved for Public ReleaseNovember 25, 2008

“The Mexican possibility may seem less likely, but the government, its politicians, police, and judicial infrastructure are all under sustained assault and pressure by criminal gangs and drug cartels."

I guess that they are not **our** criminal gangs and drug cartels or it would be OK.

We live in central Mexico. At present the economy is chugging along, construction happening everywhere as an unstoppable stream of gringos hasten to build in the Guadalajara (and other) vicinity(ies).

Deep breath... y'all never did get Mexico, it seems. See there's quite a vibrant street economy here for one (neighbors sell roasted chickens, tacos, candy etc to their neighbors all over), two people have land/homes/livestock free and clear and grow their own stuff a great deal, three, they don't think much of their gummnt, never did. The gummnt is parasitic in the opinion of the people. They endure it like weather which can not be controlled, but are not so prone to rely on it outside of the large cities. As for the cops, forget it, you'll see Mexicans collide in autos, shrug, and drive away. No one wants police around. Having hundreds of years' worth of extended family relations, with the exception of concentrations of strangers in big cities and tourist holes, people figure out what to do among themselves.

It's native america. These people have been around for millenia. They're the antithesis of what's across the border, people who can't even think for themselves without some official approval too much of the time. These people live around their government.

I'm not saying hard times won't come. But never will it crash and splinter like a juggernaut the way the US will.

I know, "the teevee says, the teevee says..." I read that hallucinatory bit about millions of Mexicans supposedly preparing themselves to mob the US to find food. This is ridiculous. And it illustrates so well how little idea most US people have, as to where their food comes from or how it gets to them.

What you're seeing is one of the US' insane propaganda campaigns, to get the public nodding like a drinky-bird in acceptance of more police state GOP insider-money pork barrel defense spending.

Mexico may see cessation of a lot but people are NOT starving. We've driven all over the interior, and aside from gringo haunts NO ONE ever begs. In fact they tend to give you food, share whatever they have.

I'll have to check back later when my blood pressure drops again. The US media propaganda campaign against Mexico is so flipped out, I can't find perjoratives salty enough to match it. What's really sick is that the US people have no idea how utterly manipulated they are by their media and gummnt.

I can't say enough about how much my yogic journey has done for my posture, stress management, mental health, flexibility, and breath quality!

I'd also like to put in a plug for Pilates, which is as effective as yoga. However, I would say that Pilates is a bit more core-focused and less flexibility-focused than yoga.

I still look to weights and distance running for the bulk of my strength and cardio needs. However, I am certain that my yoga and Pilates study have helped improve my form and made me a far more efficient lifter and runner than I would be otherwise.

Anon, don't be so hard on yourself, I am sure you are not dull, perhaps bombastic but not dull.

"Trillions of dollars are gone through house price declines"

What percentage, would you say, of those trillions of dollars you mention above have any velocity?

I still interpret this as saying gone, therefore zero. As for your example:If I own a house worth a trillion dollars and some twerp says, "okay my friend it is now of zero value." What effect does that have if I do not have it on the market.I would say you are smoking some serious ganja if you think your house is worth a trillion dollars. But more seriously, if enough twerps think it is worth zero then it is, until you find someone who will pay more. ( And if we are going to continue to nitpick, since you are not selling it, it also has a velocity of zero) As for the actual velocity of remaining equity, I have no idea how to make a formal calculation, if anybody has a idea chime in, but it would have to have some combination of components; the actual sale price (as I just mention) and the rate of actual closings on house sales ( a number which is down these days by quite a lot) So to sum up I will WRITE again (not speak btw) the lost equity has a velocity of zero and the remaining equity has a velocity of somewhere between zero (because of hopefully temporary credit disruptions or becuase you are voluntarily not selling)and not much higher because sales are so low.Take a chill pill.

In the last four years, I have spent about 6 months in Peru. During that time, I have never, ever seen a non-pirated DVD or software installation disc anywhere. Even the masters in the DVD kiosks along the streets are blanks. I highly suspect that an official DVD or software installation disk has ever crossed a Peruvian international boundary with the exception of in the luggage of Norteño tourists.

“Any descent by the Mexico into chaos would demand an American response based on the serious implications for homeland security alone.”

That is the bit that stuck out to me.

“I guess that they are not **our** criminal gangs and drug cartels or it would be OK.”-- el gallinazo

“What you're seeing is one of the US' insane propaganda campaigns, to get the public nodding like a drinky-bird in acceptance of more police state GOP insider-money pork barrel defense spending.”-- adios a babilonia

“…would demand an American response” Like invade? If it was just a financial terrorists thing the U.S. public could all go back to sleep.

“EL PASO - Mexico is one of two countries that "bear consideration for a rapid and sudden collapse," according to a report by the U.S. Joint Forces Command on worldwide security threats.

The command's "Joint Operating Environment (JOE 2008)" report, which contains projections of global threats and potential next wars, puts Pakistan on the same level as Mexico.” http://www.elpasotimes.com/newupdated/ci_11444354

Hey, anybody remember that little demonizing bit about WMD's?

So the US is still paying attention to the same sources who brought that about?

Hasn't anyone figured out that the corporate/militarist planet ponzi kings thrive on demonization and public *terror* campaigns?

Just for the record we live 25 miles from Guadalajara in a 500 year old village. Our gardener/neighbor/friend has 17 siblings, and may be related to everyone on this block. Everyone knows everyone (not true in big cities). In two years of living in this village, like most every family here we have a masonry garden wall behind which we park our truck. Anybody could hop over it, but no one ever has. The key is on the floor, and it's a Toy4. The door to the condo stays open, or if on account of rain we close it, we leave the key in the door. We usually forget to lock the truck where we keep 100's of $$ worth of tools, highly visible under the camper shell. No one has ever taken a thing.

There are no strangers in town. Perhaps 95% of the people look into each other's eyes upon passing and greet each other. It is a joy to behold these people.

As I wrote to a friend, we aren't in Mexico for the absence of crime. We are here for the presence of these people. If they aren't the best folks on earth, they'll do.

Note: there are no *safe gummnts* - there are only places and people.

But I sure wish the slander campaign of the US - trying to drum up war with her neighbor - would sizzle out and go back to hell from whence it came.

“One is struck by the similarities with the Savings and Loan scandal which was allowed to continue through the Reagan 1980s, long after it became apparent that deliberate bankruptcy was being used by unscrupulous profiteers to amass illegal fortunes at what was ultimately public expense.25

In the same way, the long drawn-out housing bubble of the current Bush decade, and particularly the derivative bubble that was floated upon it, allowed the Bush administration to help offset the trillion-dollar-plus cost of its Iraq misadventure,26 by creating spurious securities that sold for hundreds of billions, not just in the United States, but through the rest of the world.

In the long run, this was not a sustainable source of wealth for America’s financial class, which is now suffering like everyone else from the consequent recession. But in the short run, the financial crisis and bailout made it possible for Bush to wage a costly war without experiencing the kind of debilitating inflation that was brought on by America’s Vietnam War.

The trillion dollar meltdown,27 in other words, can be rationalized as having helped finance the Iraq War. When we turn to the martial law preparations, however, they are being made in anticipation of civil unrest in the future. Why such intense preparation for this?

The obvious answer of course is memory of the rioting that occurred in San Francisco and elsewhere during the great depression of the 1930s. Indeed that thought may be uppermost among those who recently arranged for the redeployment of a Brigade Combat Team from Iraq to America. But the planning for martial law in America dates back almost three decades, from the days when Reagan appointed Rumsfeld, Cheney and others to plan secretly for what was misleadingly called Continuity [i.e., Change] of Government.”Martial Law, the Financial Bailout, and War Prof. Peter Dale Scott

"Consumer spending, which accounts for more than two-thirds of the economy, has virtually dried up since mid-September as the problems on Wall Street began to spread. With the uncertainty of jobs weighing on consumers, economists do not expect a turnaround anytime soon."

the people are not going to spend until they see the economy starting to get better. unless it's for something essential, like food, utilities, etc. just plain necessities for everyday business at home. like the fridge broke down, the washer or dryer just broke. combined with the possibility of losing ones job, not many people are gonna spend $$$.

so basically the lenders don't want to lend and the borrowers don't want to borrow. (because they are tapped out).

is this not a standoff? eventually someone will give in.who will it be? the lender? or the borrower?

While one could get the lenders going again by opening their books, that's the same trickle-down economic thinking that is so pervasive on Wall Street, Washington, and unfortunately here at TAE.

Even if they start lending again, without well paying jobs, nothing is going to happen.

And you won't replace the staggering job loss that we've seen (and will keep seeing) in any quick fashion. There's just too much pressure by the Chamber of Commerce and its ilk to drive American wages to third-world standards.

So this mess isn't going to be solved any time soon. Two years is hopelessly optimistic.

I like to think (andthe sooner the better!)of a cybernetic meadowwhere mammals and computerslive together in mutuallyprogramming harmonylike pure watertouching clear sky.

I like to think (right now, please!)of a cybernetic forestfilled with pines and electronicswhere deer stroll peacefullypast computersas if they were flowerswith spinning blossoms.

I like to think (it has to be!)of a cybernetic ecologywhere we are free of our laborsand joined back to nature,returned to our mammalbrothers and sisters,and all watched overby machines of loving grace.

Thinking about the endless articles provided by our hosts,showing the rotted center of the corpse, has got me to try and think of some way it can all be made right...that like ol'billy boy clinton,some how,some way,Obama works some Pure F#@*% magic,pulls a BIG rabbit out of a hat....and succeeds in blowing up another bubble...say in the alternative energy ...A solar panel/windmill/nuke reactor in every house 100k miles of new railways ect ect....

How soon would the reality of peak cut this off at the knees.Is it possible to do this,even partially ..for a couple of years?

OK, I'm sorry, I've read all the comments and I still don't get why you can't have inflation until you have economic recovery. Surely you get inflation when the money supply increases relative to the things people want to buy? So you could get inflation by holding the money supply constant and reducing the supply of, say, food?

So we've got asset deflation, and now we've got job losses and manufacturing falls. If the fall in productivity overshoots the fall in money supply, doesn't that generate inflation in the absence of recovery?

About confidence and the view that business confidence is down...It isn't business that inspires doubt and distrust it is the players, the leadership. Am I alone in perceiving our political leaders as bought and paid for agents of some unknown hand? Am I alone in perceiving the same foxes that gorged on the henhouse contents being promoted,applauded for their " efforts" to run the system into the ground? some are awarded medals, doctorates etc... I have a weird internal representation of the financial leadership. They are genetically unique with a long ant eater snout enabling access to the bones of the system, sucking the marrow from within. Clever really as there is no change in the appearance of the bones. Nobody notices until they crumble under stress. Confidence in a system cannot exist without confidence in the system operators. A bailed out system is still bone brittle. I don't trust it. Do you?

Snuffy said "...Obama...pulls a BIG rabbit out of the hat..." Ha! Now we have a new archetype for President- THE MAGICIAN!Up here in Canada it is very politically incorrect to doubt Obama's ability to save/change the world. He has been chosen by the people with the endorsement of god. To express doubt is to somehow jinx the magic. And Cdns see Obama's upcoming visit as preferential, hope that some of the magic dust will rub off on Cdn affairs.The options seems to have narrowed to 2 camps- critical thinkers and magical thinkers.Me, I'm keeping my head down! Snuffy, I really enjoy reading about your successful preparations!

“EL PASO - Mexico is one of two countries that "bear consideration for a rapid and sudden collapse," according to a report by the U.S. Joint Forces Command on worldwide security threats.

The command's "Joint Operating Environment (JOE 2008)" report, which contains projections of global threats and potential next wars, puts Pakistan on the same level as Mexico.” http://www.elpasotimes.com/newupdated/ci_11444354

Given that this does not accurately reflect the situation here, is this some *death threat* from Planet Ponzi?

Are we supposed to become a Palestine for the US down here?

Remember, the people and office who issued this blurb about Mexico have no history of speaking the truth about anything. But I read another disinformation report, with Chertoff's people claiming millions of starving Mexicans were on the brink of crashing the border northward in search of food.

We've been up and down and across the interior on trips over two years, enough to know better, not to mention that the north is choked with ejidos lands rented by such as Heinz, Ponzi kings farms, which produce is all destined for the states. It's not like there's not food down here.

What has me worried is that they just discovered the world's biggest vein of gold in Guanajuato. In fact we planned to move there until they started doing core samplings above town - various complications and concern about public water supply, not to mention concern about international envy given the gold/Ponzi equation.

Is this what this is?

Is homeland security (an expression I loathe) up to no good against its neighbor?

The Ponzi kings in their quest for oil and gold? Somebody wants the gold, eh? Is that what this inflammatory pronouncement is about?

Or just working up the US public to a fretful state of *terror* again?

As to the "successful"preps,scandia,too soon reality will be "load testing"my preps.We can discuss "success"after load test

Latest effort[yesterday/today]discuss with the local Indian tribe use of land on the res. for bees...we will see how this shakes out..

Who ever is the clown that is coming up with the "armed intervention "BS about Mexico has failed to note that Mexicans take a real dim view of norte americanos running around w/guns on THEIR ground..."To die for the sacred soil of Mexico" would become as pastime,and we got one hellava amount of of very patriotic mexicans up here....this is just a bad,bad idea.Someone in that group is cracked...

No kidding, in my unarmed way I'm having my own deeply patriotic moment about our new home/people.

Reading this insanely spun "notice" which puts Mexico on a par with Pakistan reminds me of that scene in the Godfather where the guy find's his horse's head in the bed. It is very menacing speech.

I can only hope that the world gets the straight story about what is going on. US people are an unstable public, very accustomed to axiomatic PR myths (eg "librul/conservative") and I'm afraid for this news working them up into a disinformed frenzy.

And you are right. Mexican people won't have it. I had a dispute with a major blogger who will go unnamed, that if the US keeps messing with Mexicans, the 90 percentile of legal workers up north will simply retreat home - in search of food, no less, upon future collapse of US infrastructure. This would cripple US society. They have no idea how to fill in for the *kitchen help* whom they so unjustifiably insult and mock.

Sorry Illargi, but your understanding and arguments regarding inflation and deflation (and in your previous article "The Grief Cycle" you are just plain wrong. Pick up an introductory economics textbook sometime, published anytime between 1800 and the present day.

Sorry Illargi, most of these posters are right, your absolutist and reductio ad absurdium arguments do not carry any weight. Brighter guys than you have already pulled the inflation vs. deflation argument apart.

Laughingriver hit it right on the head, "....we will go through a depression who's first phase will be deflationary and who's second, much longer phase will be hyper-inflationary because the currency will crash. Already we can see that there will be no funding for the stimulus as there simply is no real physical money available to finance it and there will be serious competition for any and all available cash all around the world."

From Bloomberg:"Billionaire Warren Buffett said the economy “has fallen off a cliff” and that efforts to stimulate recovery may lead to INFLATION higher than the 1970s."http://www.bloomberg.com/apps/news?pid=20601081&sid=akYoIqUfMfYY&refer=australiaBut what does he know, anyway?

"Next year the fiction will be dispelled that governments can stop debt deflation by means that do not either produce mass unemployment or horrific inflation. As they try and repeatedly fail to meet expectations the Period of False Hope and Uncertainty will give way to the Era of Total Despair, and then we will finally see a bottom. Lost and wandering the ideological landscape with all of the old beliefs washed out, men go mad and grasp for any explanation but the truth -- that the debt must be deflated before recovery can begin -- and anything can happen. Watch Kudlow’s show and you’ll see what I mean.

Economic eras may share similarities but not two are alike. What worked in the last debt deflation will not work now, and what did not work then will most certainly not work now. In debt deflation governments are either fighting the last economic war or some ancient war fought under conditions that will never recur, but all the same the root causes are alike: the economic delusions produced by excess credit.

The US cannot export its way out of debt as Japan did from 1990 until recently – and what will happen to Japan in this recession with its public debt now 193% of GDP? We hear that Asia will lend no more, so the US cannot borrow its way out of debt.

At least iTulip readers can resign ourselves to our fate, and the sooner the better. There are consequences to debt. How shall we take it, by inflation or deflation? I say inflation is inevitable, so let's get it over with."http://www.itulip.com/forums/showthread.php?p=62889#post62889